The Intelligent Future of Active Fund Management: A UCL BIT seminar
If you won an unbiased coin toss 100 times over, would you think “I’m pretty lucky” or “I’m skilled at calling the result of a coin toss”? If you think the latter, then you do not understand randomness. You could say that 100% accuracy was a genuinely great performance, but can we really equate that performance with skill?
On the 29th of October, we hosted CEO and Founder of Essentia Analytics, Clare Flynn Levy, for a webinar titled Behavioural Alpha: The Intelligent Future of Active Fund Management. In other words, a future where fund managers can identify and isolate the negative impacts of the biases in their behaviour. In turn, they will not only improve their performance but finally outperform the dastardly index fund.
Index funds that, until now, they have largely been unable to outperform. A portfolio manager’s job isn’t really like calling the outcome of a coin toss — they make well-informed positioning decisions and have various ways to uptake those positions — so surely their performance is a good measure of their skill.
Not quite, according to Flynn Levy, because as she points out “performance is a measure of outcome”, not skill. Performance and skill are of course related, as “performance is a function of skill.” However, it is also “a function of luck”. No investor should be luckier than another in the long run, “so we shouldn’t really be too surprised that they haven’t been outperforming randomness.” Similarly, in the long run, I should not be shocked if I fail to predict the outcome of a coin toss most of the time.
“so we shouldn’t really be too surprised that they haven’t been outperforming randomness.”
In fact, Essentia has found that portfolio managers tend to “round-trip”, or destroy the value they earn, and if it was not for the round-trip they could outperform index funds (see The Alpha Lifecycle). So the question arises, how can a portfolio manager retain the value they earn? Well, Flynn Levy claims 75% of Essentia’s clients “improved their annual alpha generation by an average of 170bps [1.7%]” after one year.
This is what Flynn Levy has dubbed the “behavioural alpha” advantage, and it could be the future of fund management. In her own words, behavioural alpha is “the excess investment return… over and above a benchmark that results from mitigating the biases hidden in your own decision-making process.”
Dividing skilled investment decisions broadly into those that are conscious and those that are unconscious, the latter enabling potential bias to negatively impact performance. The value-destruction (loss of alpha) originates from the portfolio manager’s unconscious decisions because such decision-making processes are the realm of system 1, and therefore open to bias.
behavioural alpha is “the excess investment return… over and above a benchmark that results from mitigating the biases hidden in your own decision-making process.”
Consider the coin toss again. After a 100% strike rate you would feel pretty confident, maybe even overconfident, in your abilities. Especially if you believed that your skill contributed to the strike rate. when offered to bet on the next toss, you might be inclined to take more risk than is strictly rational. You could be confident in your ability to get it right, coming to the answer quickly, and blindsided when you get it wrong. Your feeling of overconfidence has swayed your judgement. You may implicitly believe that you will continue to get it right. When decision-making in complex and unpredictable environments like markets, you might draw similarly biased conclusions. But, as Flynn Levy points out, “when you are in it, it is not so clear.”
One curious participant wondered specifically how emotions influence the decision-making process. “That’s a very interesting piece of the puzzle. And it’s a tricky one” Flynn Levy answered. To fully determine the interaction between emotion, physical states and decision-making you need a continuous time series of data for emotion and physical state. However, they do have some of that information at Essentia. Flynn Levy points out it is a process. “We hypothesize that different patterns are the result of certain biases. But ultimately, what matters is the pattern.”
“… what matters is the pattern.”
To generate behaviour alpha, Essentia recognises value-destroying behaviour and provide portfolio managers with a method to control their biased decision making. Control made possible by a data-driven feedback loop for continuous improvement. At the base of this lie nudges.
“When we talk about nudges there’s nothing subtle about it. You know, these aren’t sort of little background ways of herding people in one direction or another without them necessarily realizing it. This is literally a tap on the shoulder.”
But one participant wondered how exactly Essentia managed to convince those confident portfolio managers to be nudged and question their decision making. What kind of client is Essentia looking for?
“People who are, we would say, skilled but humble. You know, it’s a certain type of person that’s willing to look in the mirror and is secure enough in themselves to know that if they see things that are not exactly what they wish they would see that it’s not going to undermine them completely. Those are the people that we want to work with.”
Ultimately, Essentia’s results are as good a motivation as any. That is not the only factor, but when reliably higher returns are on the table it is hard not to be swayed.
If you enjoyed this article and want to learn more then here is some further reading recommended by Flynn Levy.
- The Essentia Blog: https://www.essentia-analytics.com/essentia-blog/
- Essentia White Papers: https://www.essentia-analytics.com/essentia-white-papers/
- Peak, Anders Ericsson
- The Checklist, Atul Gawande
- The Success Equation, Michael Mauboussin
- Essentialism: The Disciplined Pursuit of Less, Greg McKeown
- The Spirit of Kaizen, Rober Maurer
- Nudge, Thaler & Sunstien
