Key Questions: Investment Manager Outperformance: Skill vs. Luck

In our recent Key Question “What Makes a Good Investment Manager?,” we highlighted the 8Ps framework that Key’s Multi-Strategy Research team uses to identify quality managers. As part of this process, the team is faced with an additional layer of complexity: If a manager has outperformed, is the outperformance driven by skill or simply luck?

In this article, we discuss the four key questions we ask in disaggregating performance and, importantly, ascertaining whether we can reasonably expect outperformance to continue. At a high level, we must find evidence of skill and a market opportunity (defined below) in which to exploit this skill.

The Four Questions

1. Is there evidence of sustained outperformance (alpha)?

The first criterion for recognizing skill is the generation of sustained outperformance, also known as alpha. Alpha refers to the excess returns of an investment relative to an appropriate benchmark index. A manager must consistently deliver returns above the benchmark to be considered skillful. This involves evaluating active investments against the passive strategy that most closely mirrors their market exposure. For instance, a U.S. small-cap equity manager should be assessed against the iShares Core S&P Small-Cap ETF (IJR) to ensure the benchmark is investable and relevant. If a quantitative analysis shows that a strategy has generated consistent alpha, we can move on to the second question.

2. Is the alpha driven by the manager’s stated investment strategy?

We then focus on whether the alpha is driven by the manager's stated investment strategy. This requires analyzing returns across various time periods and market environments to confirm the persistence of alpha. Our evaluations extend beyond market downturns and include periods when specific factors yield returns significantly different from the overall index performance. By using advanced analytical tools, we identify residual returns that surpass expected factor-related returns, indicating that a manager’s alpha is indeed driven by skill.

3. Is the skill sustainable?

When persistent alpha is identified, we delve into the qualitative drivers behind it. This includes examining unique sourcing capabilities, innovative investment processes, exceptional human capital, or superior portfolio construction methodologies. Often, a combination of these qualitative factors provides reasonable evidence of an active manager's sustainable skill. Importantly, we evaluate whether we have reason to believe that these qualitative drivers should persist. For instance, is there any risk of a key employee moving on? Is the portfolio construction methodology changing?

4. Is there a market opportunity to employ manager skill?

Finally, the identified skill must align with a market opportunity conducive to alpha generation. Typically, inefficient market segments, characterized by greater return dispersion, offer the best environments for applying a manager's expertise. For example, the small-cap sector generally presents more opportunities for alpha than large-cap names because of its inefficiencies. We must feel strongly that a skillful manager is “fishing in the right pond” to move forward with a recommendation.

Conclusion: Distinguishing Skill From Luck

Statistics show that most active managers don’t outperform over the long run.¹ This evidence points to the fact that even managers that outperform over the short term are often buoyed by simple luck. The onus of the Multi-Strategy Research team is to identify managers with a higher-than-expected likelihood of outperforming their respective benchmarks. By asking ourselves the key questions highlighted above, we can significantly improve our prospects of choosing skillful managers that generate persistent alpha.