Maximizing Performance

CEO Bill: “Frank, we see that the Super Alpha Generator strategy is underperforming. Can you provide some insights and colour to this?

PM Frank: “Insight into our underperformance is a great question, Bill. Looking at the market and the movement of our holdings, we have underperformed due to market conditions. Our strategy is solid and over the long will produce what we are looking for.”

If market conditions is your firm’s favourite response to your performance, you’re under-utilizing performance. Performance is a feedback tool designed to calculate and understand the reasons (sources) behind your returns. The existence of performance measurement was for the specific reason to be able to identify alpha-generators from alpha-pretenders. That desire to unearth sources of returns has developed performance into the field it is today.

If investors were solely interested in the calculation of the return, they would have stopped at the TWR or even Holding Period return. By not delving deep into the sources of your returns, in an unbiased manner, you are just masking underlying issues. It may lead to a false sense of skill where instead you have been benefitting from luck. As we all know, there’s as much bad luck as there is good.

What should we be looking at?

The beginning:

Performance starts with the most basic question: did we make money. If you have earned a positive absolute return, then the answer is yes. If negative, then no. The second question should be: how well would we have done investing the benchmark instead (i.e., a passive approach to our strategy)? If you have outperformed the benchmark, that is positive alpha, then there is something in your active management that seems to be paying off. If you have underperformed, that is negative alpha, perhaps your thesis may not be correct. In the end, it may all just be noise. With greater data points and longer return periods, we get to see more concrete evidence of what is going on.

Digging deep:

Are we done now? Should that be sufficient? What if the firm or PM starts crediting themselves for all this outperformance and, as required, indicate past performance is not an indicator of future performance. Although that statement is true, genuine alpha generators are able to replicate outperformance over long periods of time. Alpha pretenders may have specific moment of outperformance, be credited as investment gurus, but never really be able to replicate their outperformance going forward.

We need to dig deeper into the how were the returns were generated. Using a combination of contribution and attribution analysis, as well as adding risk analysis, will provide your firm the opportunity to better understand whether your thesis is valid. We can analyze from the asset class/ security selection point-of-view, or we can even take a firm/manager point-of -view, all valid approaches that will provide a more well rounded and comprehensive understanding of what and who is contributing to performance.

Lastly, we can’t ignore qualitative analysis, in other words the middle child of the field. Qualitative analysis is an often-overlooked approach to performance analysis. It doesn’t provide the sexy numbers, graphs and charts that the quantitative side does. It is an approach that asks questions to the firm’s decision makers in better understanding their reasoning in their decisions. Keeping track of this information over time allows you to better understand if a manager has a legitimate thesis and is not using the words of the day to explain away good and bad performance.  Digging deep into the qualitative provides additional information that, along with the quantitative side, provides you the most comprehensive understanding of how and why you are generating the performance you have.

Performance tools are readily available for all firms and managers. Don’t be scared to maximize them and help benefit your firm and its clients. Find the alpha-generators, hold onto them, and reward them.