Evidence-Based Active Manager Investing

The primary focus of our research is on how to pick stocks and construct equity portfolios. But we understand that for many of our readers the primary concern seems to rather be how to pick managers.

In our view the problem is that everyone claims to have an edge. They wouldn’t be much of a manager if they didn’t. So the difficulty becomes cutting through the claim to understand what backs it up.

This week we reviewed some literature on how to pick managers and the characteristics that often separate good active management from bad. We have summarized these findings in the table below.

Figure 1: Summary of Predictive Management Factors

Sources: Getmansky (2012), Yin (2015), Zambrana + Zapatero (2015), Vanguard, Gupta & Sachdeva (2017) , Cremers & Petajisto (2009), Grove et al., (2000), Bloomberg (2017), Piotroski (2013), Davis/Dalbar (2012)

At Verdad, we have focused on building a business model and strategy that are consistent with evidence. Our goal is excellence, as defined by alpha generation. And we plan to achieve that goal by developing and exploiting niche, capacity-constrained strategies that we believe are rooted in logic and supported by long-term empirical research. We think such a model allows us to offer an honest alpha strategy in which we are thrilled to invest alongside our investors.

For practical reasons, not all asset allocators can find managers that meet all of these criteria. Size is often the biggest hindrance. A strategy whose capacity constraint is under $100M – no matter how good – simply might not be a good fit for an asset allocator with billions of dollars to deploy. Likewise, some managers are tempted to stray from their bread and butter in an effort to grow assets and appeal to larger pools of capital. 

In our view, finding a manager with the evidence-based characteristics and approaches above doesn’t guarantee performance by any means. And, by extension, the absence of these factors doesn’t necessarily doom a manager. But we hope this provides a framework for how we think about identifying winning strategies that have the potential to produce sustainable, long-term alpha.