The most important skill metric of the portfolio manager is often overlooked.
I often hear fund managers say, “I only need to get it right a little over 50% of the time.” What they are referring to is the hit rate. is similar to batting average in baseball: Represents the percentage of your decisions that generate money, in absolute or relative terms. And yes, the ideal is to achieve a decision success rate of more than 50%, whether you are a fund manager or a normal person in everyday life, right?
However, the fact is that most fund managers have a success rate in their overall decision making of less than 50%. Our recent study, The Alpha Behavior Benchmark, found that only 18% of portfolio managers make more value-adding decisions than value-destroying ones. We examined trading behavior across 76 portfolios over three years and isolated the outcome of investment decisions into seven key areas: stock selection, entry time, size, scaling, sizing, scaling, and exit time.
Among our findings: While the hit rate gets a lot of attention, it is often less consequential than the reward. A good pay rate can more than make up for a hit rate below 50%, and a bad pay rate can completely negate the effect of a strong hit rate.
Here’s why: Pay measures whether a manager’s good decisions have generally made more than his bad decisions have lost. It is expressed as a percentage: More than 100% is good; less than 100% is bad. A few decisions with payoffs well above 100% can more than make up for several that fall below the 100% mark.
He didn’t use the term, but the legendary Peter Lynch emphasized reward as a key theme: In 1990, he said wall street weekIt’s Louis Rukeyser who “You only need one or two good deeds per decade.” Those would have to be VERY good stocks, of course, but the point is that profitability is one of the most critical factors in a successful professional investing. Successful managers must ensure that their winners win more overall than their losers lose.
It is perhaps ironic, then, that asset owners and allocators examine a wide variety of manager stats in an effort to separate luck from skill, but they tend to overlook the reward. In fact, pay is one of the purest skill metrics out there. Managers who consistently achieve greater than 100% returns exhibit true investing skill: They know when to hold them and when to withdraw them.
Essential Behavioral Alpha Frontier
The ability to weed out losers and indeed cut off winners before they become losers — is what the best investors are good at. And that manifests itself in a great reward.
The diagram above comes from The Alpha Behavior Benchmark. It looks at all the trading decisions made by our sample of 76 active stock portfolios over the last three years and plots their hit rate against their payout. The dashed line represents what would be achieved by chance: if the manager is correct half the time with a 50% hit rate and his average winner wins exactly as much as his average loser loses for a payout of 100%.
While managers’ success rates fall in a fairly narrow band along the X axis, their payouts vary dramatically along the Y axis. The top five managers, colored in magenta, have high hit rates and high payouts.
This diagram, and its use of payout as a key comparative metric for portfolio managers, represents an important next step in the evolution of manager evaluation methodology. It allows us to look beyond traditional evaluation metrics based on past performance, which are highly subject to the random effects of luck and therefore have limited usefulness, and focus instead on the quality of decision making. decisions of a manager. And that’s a much more accurate assessment of his ability.
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All messages are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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Clare Flynn Levy
