Portfolio Manager Skill Evaluation

Evaluating the skill of an investment manager involves analyzing their ability to outperform benchmarks and peers through attribution and appraisal analysis. Here’s a breakdown of how these evaluations work and their implications.

Attribution Analysis Example

Scenario:

• Manager X underperformed their benchmark, the Euronext 100, by 67 basis points (bps).
• The goal is to determine whether this underperformance is due to lack of skill or bad luck.

Key Findings:

1. Allocation Effect:
   • Manager X’s country weighting decisions led to a loss of 12 bps.
   • Key observations:
     • Positive: Underweighted the Netherlands by 4%, which underperformed the benchmark by 2.34%, adding 9 bps.
     • Negative: Made poor decisions in other countries:
       • Underweighted France by 3% (which outperformed by 1.50%), losing 4 bps.
       • Overweighted Belgium by 4% (which underperformed by 1.87%), losing 7 bps.
   • Conclusion: Manager X struggled with country allocation, especially in France and Belgium.
2. Selection Effect:
   • Stock selection caused a loss of 56 bps.
   • Key observations:
     • Positive: Picked outperforming stocks in the Netherlands and Belgium, gaining 32 bps.
     • Negative: Poor stock selection in France led to 81 bps loss.
   • Conclusion: Stock selection was a significant contributor to underperformance, particularly in France.

Overall Attribution:

• Total underperformance: 67 bps.
  • Allocation: 12 bps loss.
  • Selection + Interaction: 56 bps loss.
• Conclusion: Manager X underperformed primarily due to poor stock selection and country allocation, indicating a lack of skill.

Appraisal Analysis Example

Scenario:

• Comparing performance metrics for Managers X, Y, and Z against a common benchmark.

Key Observations:

1. Risk-Adjusted Performance:
   • Sharpe Ratio:
     • Manager X underperformed the benchmark and Manager Y, with a ratio of 0.63 vs. 0.67 and 0.68, respectively.
     • Outperformed Manager Z (0.61).
   • Treynor Ratio:
     • Manager X’s ratio (0.07) was below the benchmark and Manager Y (both 0.08).
     • Outperformed Manager Z (0.06).
2. Alpha and Tracking Error:
   • Information Ratio (IR):
     • Manager X: Negative IR of (0.22) indicates underperformance relative to the benchmark.
     • Manager Y: Positive IR of 0.41, showing superior performance.
     • Manager Z: Poor IR of (0.72), indicating significant underperformance.
3. Downside Risk:
   • Sortino Ratio:
     • Manager X: 0.75, better than the Sharpe ratio of 0.63. Indicates better performance relative to downside risk.
     • However, Manager Y (0.78) and the benchmark (0.87) both performed better.

Conclusion:

• Performance vs. Benchmark:
  • Manager X underperformed the benchmark, particularly in risk-adjusted metrics.
• Peer Comparison:
  • Manager X outperformed Manager Z but fell short compared to Manager Y.
• Recommendation:
  • Consider replacing Manager X with a manager who demonstrates better skill in country allocation and stock selection, as well as superior risk-adjusted performance.

Takeaways:

1. Attribution analysis highlights specific areas (e.g., allocation, selection) where skill is lacking or evident.
2. Appraisal analysis quantifies performance against benchmarks and peers, offering insights into risk-adjusted returns.
3. Combining both approaches allows stakeholders to make informed decisions about retaining or replacing a manager.