The greatest obstacle to discovery is not ignorance, it is the illusion of knowledges – Daniel J. Boorstin
Complex systems such as competitive sports and investing require a mastery of the fundamentals. For investing, this comprises a thorough understanding of markets and the associated sources of inefficiency. Most research analysts have significant financial education, including undergraduate and graduate courses in economics, accounting and finance.
Many have completed the intensive CFA® program as well. A relatively small number of analysts also have significant experience selecting assets and building portfolios. As a result, most research practitioners believe they have a comprehensive understanding of capital market behavior. But do they?
Nearly all manager research processes include a detailed list of the key elements that analysts review: performance, portfolios, processes and people. Most analyst write-ups rightly stress the need to balance the art of qualitative subjective assessments with the science of rigorous quantitative analysis. However, analyst ratings and the checklists and rationales that support them often fail to sufficiently consider which market anomalies managers are attempting to exploit, why these anomalies should continue to exist and how they can best be captured.
Capital markets knowledge – the most important element of the evaluation process – often receives insufficient attention during the manager research process. The essential purpose of manager research is to generate a sound forecast of future performance. In order to make an effective forecast, analysts must apply a deep understanding of how markets behave and specifically how assets become mispriced. The key to the discovery process is determining how well managers understand inefficiencies and how best to capture them. Research analysts must carefully consider how behavioral bias impacts asset pricing and also how it can impact their own decisions.
Gain the knowledge, but beware
Beyond formal education and actual investing experience, successful research analysts must continue to explore the mysteries of the capital markets. Three primary methods exist to acquire detailed knowledge of market inefficiencies and related opportunities.
The first is academic research. The collective body of knowledge on anomalies is vast. But beware, prioritizing and synthesizing these results requires extensive context and effort. Most research practitioners necessarily limit their attention to a narrow set of findings.
Second is individual and collective primary research. Most major manager research efforts include hypothesis generation and testing with detailed holdings and performance data that has been collected by the firm over the years. However, this process is generally time-consuming and doing it well requires significant effort in amending or removing data that is incorrect, incomplete or duplicated. Plus, it is challenging to generate relevant hypotheses to test, and interpreting results is fraught with behavioral bias.
Finally, there is manager insight. Arguably, the best source of information on market inefficiencies is provided by practitioners. But remember, manager research analysts fall prey to not just performance chasing but confusing what has worked well for a given time period or market regime with what will work well in the future. It is extremely common for managers to confuse their own success with insight. Managers who have outperformed peers demonstrate more conviction and are more articulate in describing why their strategy has worked so well and will continue to do so. Analysts tend to respond more favorably to strong conviction and effective articulation when it coincides with strong historical performance. As with many portfolio managers, research analysts’ forecasts are skewed due to their overconfidence.
Get some perspective
Specialization of coverage and extensive experience can help build market knowledge and appropriate skepticism. Engaged analysts who specialize in certain market segments have the opportunity to build and apply their knowledge over time. For example, an analyst who specializes in small-cap manager research benefits from:
- Having a strong preference for managers that limit assets under management in order to maintain portfolio flexibility and liquidity. It is important to use analytical tools to measure this quantitatively and explicitly.
- Understanding the effect of exchange-traded fund (ETF) flows on short-term prices (including the response to ‘risk-on’ and ‘risk-off’ ETF flows using instruments such as the Russell 2000 ETF) and assessing how prone a manager’s holdings are to those flows.
- Understanding and assessing the potential price reaction to company or market news, based on the other owners of a stock.
- Assessing the uniqueness of a portfolio versus peers. A manager says they hunt in the market where others don’t, but are many of their stocks recognizable and do they have an abundance of sell-side coverage?
- In-depth knowledge of relevant peers’ performances within a style and sub-style helps build necessary perspective. Outlier performance is often cyclical, whether on the upside or downside, and is a result of managers’ preferred market habitat and factor biases rather than insight. Comparing exposures over time and the resulting performance can improve the assessment and forecast.
Just as in competitive sports, insufficient attention to the fundamentals makes it difficult to identify who will outperform. Without a thorough and evolving understanding of the forces that move the capital markets, research analysts are just as likely to reward managers for luck as for skill.
Mark Thurston is a founder and partner at consultancy firm Alpha Signal. He was previously head of equity manager research at Russell Investments, where he worked for 25 years.