In Pursuit of Manager Skills: Summary
You don’t know what you don’t know. The future is unpredictable, and we have all been beleaguered with the old adage that past performance is not indicative of future results. Yet, client acquisition and retention often relies heavily on top percentile performance over periods of time. So how can you be sure that you are selecting active managers that are well positioned to outperform in the future?
Here at Harbor, we aim to provide an edge to our investors in our comprehensive analysis of investment managers that transcends the assessment of past performance. The experts at Harbor do the hard work for you. While identifying active managers that produce positive alpha is a challenge, Harbor conducts thorough evaluation to deftly narrow the manager universe and identify what we believe are the highest quality managers, to help position our investors to tilt the odds in their favor.
A Study on Idiosyncratic Alpha
In a recent exercise led by Chenwei Wu and Li Ma of Harbor’s Investment Data & Enhanced Analytics (IDEA) team, we looked at historical active equity fund returns for U.S. large cap, U.S. small cap, and emerging markets categories (as defined by Morningstar) to identify those managers with results that stemmed specifically from idiosyncratic alpha, or the manager’s stock selection capabilities, stripping out the factor impact on excess returns. By focusing on idiosyncratic alpha rather than excess returns, we found that we were able to more acutely identify outperformance attributable to skill (rather than driven by cyclical influences).
Highlights of their research include:
- In terms of forecasting, higher idiosyncratic alpha amongst active strategies more effectively forecasted outperformance relative to peers than trailing excess returns. Excess returns incorporate both idiosyncratic alpha and factor impact, the latter of which can be cyclical and can drive either outperformance or underperformance. This is why we look for idiosyncratic alpha as a differentiator for our core expertise of manager selection.
- While higher idiosyncratic alpha does not necessarily lead to outperformance relative to peers, managers with low idiosyncratic alpha more frequently underperformed their peer group. Based on our research, by eliminating managers with low idiosyncratic alpha from your universe of managers to select from, you have the potential to statistically reduce your likelihood of underperformance.
- Similarly, amongst active large cap managers, we have found that while strategies with higher idiosyncratic alpha may be slightly more likely to remain a top tertile performer (as opposed to falling to the bottom tertile), strategies with low idiosyncratic alpha may be even more likely to remain in their current (bottom) tertile (as opposed to rising to the top tertile).
- In less efficient markets (such as emerging markets or small caps), underperformers have historically tended to underperform more regularly. However, we have observed from our research that the ability to identify active managers with high idiosyncratic alpha had translated to returns that were almost twice as positive as in other asset classes. In other words, skilled manager selection had the potential to deliver stronger returns in less efficient asset classes.
Going Beyond Past Performance
Wu and Ma’s study helps us better utilize returns in our manager research work, but it also underscores that past performance is of limited use in identifying best-in-class managers – something we have long known. That is why Harbor’s cadre of experts goes well beyond past performance, spending time digging into the details about the firm, the team, and its culture.
Harbor agrees that if an investor’s definition of alpha is simply excess returns, there is little to no persistency in future results based on past performance. However, at Harbor we consistently push ourselves to re-evaluate and better define what alpha looks like. By separating out the cyclical (factor) component of excess returns, the residual portion (idiosyncratic alpha) has shown evidence of persistence. While not a guarantee, investing in managers with strong idiosyncratic alpha has shown to have a basis for improving the odds for future outperformance. Again, the returns could have the potential to be higher in more inefficient asset classes.
Skilled manager selection experience is still key, in our view. At Harbor, we have many years of manager research experience that includes a deep dive on both the qualitative and quantitative aspects of a manager. We consistently strive to make our manager due diligence process more robust with new ways of measuring and evaluating alpha. We believe it benefits us by having the team doing this type of research so closely integrated with the broader manager research effort; it improves our understanding of how to evaluate active management success and identify alpha.
Harbor’s IDEA team is always hard at work splicing data and providing beneficial analysis. We further emphasize their finding that a strategy’s ability to produce idiosyncratic alpha has been more accurate at forecasting future outperformance than its historical ability in and of itself to outperform its peer group. This study only exemplifies the services and capabilities offered by Harbor that we believe are vital in recognizing managers that achieve alpha via this hard-to-replicate skill for the benefit of our investors.
The views expressed herein are those of Harbor Capital Advisors, Inc. investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice. The information provided in this presentation is for informational purposes only.
This material does not constitute investment advice and should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.
Investing entails risks and there can be no assurance that any investment will achieve profits or avoid incurring losses.
© Morningstar 2023. All rights reserved. Use of this content requires expert knowledge. It is to be used by specialist institutions only. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results.
Historical performance data starts from 12/2001 to 12/2022 for U.S. Large Cap and U.S. Small Cap, and it starts from 12/2005 to 12/2022 for Emerging Markets.
Alpha is a measure of risk (beta)-adjusted return.
Idiosyncratic Alpha is the portion of a strategy’s return not explained by the market and risk factors.
Tertile is any of three equal groups into which a population can be divided according to the distribution of values of a particular variable.