Specialist manager evaluation firm Inalytics uses quantitative processes to identify a quality previously thought unidentifiable - manager skill. Rachel Alembakis reports
"It's almost a truism that fund managers like to think of skill as something ethereal or mercurial, but it's our belief that it can be identified and we're among the first people to do it in a purely evidence-based way," said Rick Di Mascio, chief executive and founder of Inalytics.
Inalytics' clients are both pension funds and fund managers. For pension funds, Inalytics evaluates and monitors the skills of external managers for both manager selection and ongoing due diligence purposes. Fund managers will use the same services for the flip side of the coin - to see how their portfolio managers measure up, and what improvements can be made to their investment process.
"Essentially, fund managers are using us as a part of their own internal reviews as we provide objective feedback on the strengths and gaps in their investment process, so that they can refine their investment process," Di Mascio explained.
Blue Sky Group, the Netherlands-based fiduciary manager, has hired Inalytics to provide quarterly monitoring and evaluation of its external managers through the firm's Behavioural Performance Strategies (BPS) service, which both examines how fund managers' investment decisions and fund performances are affected by their personality traits and provides deeper insight into the performance of the managers.
Blue Sky Group also uses Inalytics for transaction cost analysis to monitor managers' trading efficiency and will "often" ask Inalytics to run an audit after a transition management event to provide insight into transition managers' skill, said Ramon Tol, fund manager, equities, at Blue Sky Group.
"Going forward, we will also use it in the selection process of managers. In order to be able to reduce the long list to a shortlist, we might ask managers to provide portfolio holdings to Inalytics for analysis."
Tol pointed to the fact Inalytics occupies a unique niche with its services as being part of the firm's appeal.
"I haven't come across many types of providers of this type of assessment," he said. "BPS provides us with more detail [about] where the external managers add value, with a decomposition of the performance coming from under and overweights. Sometimes the outputs surprise the managers themselves as well."
Inalytics breaks down a fund managers' performance into three areas - research, timing and trading and the firm will break down the three areas into statistical conclusions.
"We are interested in how research ideas translate into portfolio returns and we look at how every investment decision impacts the portfolio's performance," Di Mascio said.
"In terms of timing, basically it's a simple thing; if they're trading a stock, they either buy it or sell it. There are only two choices and thereafter the stocks either go up or go down. We start with that simple framework and we then get into what is really going on."
In fact, Inalytics has come out with startling conclusions when it comes to studying how managers handle the timing of investments - when they buy and when they sell. Earlier this year, the firm released a study into fund managers and the "disposition effect" - a behavioural finance theory which states that investors will typically sell a stock with positive returns too early and hold a stock with negative returns too long.
The disposition effect matters in terms of total portfolio performance - Inalytics used its Trading P&L tool, which calculates impact of purchase and sale on the total return, and found that while purchases generate 154 basis points of positive return, inopportune selling can cost 175 basis points to the portfolio.
Conventional wisdom - indeed, part of the reason for paying professional managers' fees - is that fund managers are better than amateur investors at putting aside the disposition effect. In fact, Inalytics found that while managers are good at finding stocks to buy, it is harder to find managers who know to hold winning stocks and sell losing stocks at the appropriate time.
Inalytics came to this conclusion after testing a database of 45,000 institutional trades "that represent a broad spread in terms of industry, region and benchmark", according to its research.
"We've only come to behavioural finance because we see it as one of the most robust explanations," Di Mascio said. "We've come at it from the other way around, we started out by analysing skill and then saying, yes, that really does look like behavioural science.
"I think, as a complete aside, the last 20 years have been completely dominated by modern portfolio theory, saying all investors are rational beings, and of course few people still think that that's the full story. I suppose the thing about modern portfolio theory is that it suppressed the reality of the situation [which is] that ultimately, investors are human beings with foibles and quirks, and usually, counterproductive biases."
Quant managers and the credit crunch
Recently, Inalytics' clients have been asking the firm to analyse why quantitative managers struggled so badly to perform in July and August of this year. Quant managers have developed models that provide a framework for timing purchases and sales properly, to obviate the disposition effect. However, Inalytics' initial conclusions are that their models were ineffective in the turbulent conditions of the summer.
"One of the fundamental expectations people have of quant managers, in my opinion, is that they are able to avoid the behavioural mistakes of their fundamental [manager] cousins," Di Mascio said.
"They should be systematically better at the selling and the short side of the portfolio. We don't find much evidence of that at all. "The second thing about quant managers is that you'd hope they would be able to handle market volatility and that their risk models would hold out when you need them the most - during market turmoil.
"This crisis has shown that those risk models don't work when you need them the most. They say it's a 25 standard deviation event. But that just shows that some of the assumptions are flawed. We're having a substantial amount of work on quant portfolios right now. It's something that lends itself to analysis, which is the foundation of process improvement."
Blue Sky Group is one of the clients which has asked for analysis of quant managers' problems, according to Tol.
"During this temporary quant meltdown, it seems a lot of quant managers are applying the same factors and as a consequence are in trouble. That's of great interest to us indeed," he said.
With quantitative managers looking to provide 130/30 fund solutions, Tol said Inalytics' analysis would be useful in separating out those managers that add value from skill by verifying their shorts add value.
"When these quantitative managers come up with 130/30, I think Inalytics can be at the forefront of determining where managers are able to add value," Tol said.
"It is easy to separate underweights into two classes - one [is] really underweight and the other is shorts. When you hire a 130/30 manager, it would be interesting to find if they add value with shorts."
In addition to servicing clients in the UK, continental Europe and the US, in 2007 Inalytics opened its first overseas office in Melbourne, and in June announced its first Australian client: QIC, the investment manager for the A$20bn QSuper superannuation fund. QIC uses Inalytics to analyse its domestic and international equity portfolios and will also integrate the firm's assessment into due diligence procedures in evaluating new fund managers.
"[Australia] is a very sophisticated market," said Amanda Field, managing director, Asia/ Pacific, Inalytics. "Most of the contacts here understand exactly what we're trying to do and how it can add significant value to their current due diligence process."
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