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Performance track records, in general, and performance surveys in particular, have come under considerable attack of late, and rightly so.. The fundamental problem with using rankings of past performance has been that investors see rankings or even absolute returns as indicators of skill. The reality is something far more complex. Academic research suggests that manager skill is probably the smallest component of these returns or rankings. But all is not lost. Meaning can be derived from a manager’s performance and assessments can be made about manager skill. It’s all about shifting our focus from performance measurement to performance attribution. What is the distinction? Attribution, simply defined, means to explain. In the context of investment, it is to measure whether the investment process is working, thereby analysing and quantifying the sources of return. It also highlights the strengths and weaknesses of the investment process. Let’s take the example of an equity manager. There are any number of investment decisions a manager can make to outperform their investment benchmark, whether it be some published index or just the return on cash. The manager can decide: which shares are likely to perform best; which industries are likely to outperform; which market cap or style sector is likely to outperform; and finally, whether equities as an asset class is likely to outperform. Many investment strategies incorporate elements of all of these decisions. A good performance attribution tool takes the total active (above benchmark) return of the manager and then determines how much of performance came from each of these investment decisions. More importantly, it can also tell the analyst how consistent the out (or under) performance was as a function of these decisions. Was the performance simply a function of a one-off lucky guess or was there something systematic taking place in the management of the portfolio that was adding value? Performance attribution can provide three critical insights into manager assessments. If we understand a manager’s investment strategy in advance — in other words, where the manager believes the opportunities lay in the market — we can then assess how successful (or skillful) the manager was in translating these views into outperformance. Secondly, if we don’t know the strategy in advance, we can still make assessments as to what type of decisions the manager tends to get right and what types of decisions the manager seems to be less «skilled» at. This can be key to determining what type of mandate to give a manager to ensure you extract the manager’s best capabilities. Finally, in either case, a good performance attribution model can give a clear indication of how much risk a manager took on to achieve their outperformance. The important point here is whether the performance achieved actually justified the risks taken. The reality is, there is a lot more we can do about assessing skill in managers than just look at performance rankings or manager performance histories. While past performance is never a guarantee of future performance, performance attribution analysis takes us significantly further down the road in terms of understanding exactly what was driving performance in a fund, was it intentional, and is it sustainable? If we know these capabilities exist, then isn’t it time that investors and trustees start demanding this type of analysis of their advisers and managers? Get that ranking table banned from the beauty parade! Insist instead that something more substantive be produced to give you insight into just what your fund manager is really all about. One small step for manager selection, one giant step for manager assessment. By Evelyn Andrews Evelyn Andrews is an investment research analyst at m Cubed Asset Management
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