Continuous improvement should be a key element of every fund manager's narrative

If you have been a portfolio manager over the past few years, you’re acutely aware of how exogenous forces — a global pandemic and the economic havoc it wreaked, among other things — can overwhelm the choices you made in managing your investors’ capital, no matter how thoughtful they were. You probably didn’t get every decision you made right — and now you don’t have the cover of a healthy market to help gloss over mistakes. Investors are naturally asking more questions than before.

When bad things happen, at any scale, the first thing humans want to know is why. Our brains demand narrative. When performance turns negative, humans who are paying for discretionary investment management services, whether they are investors or employers, want to hear that you understand why their portfolio lost money — and then they want to hear what you’re doing about it.

Explaining yourself becomes urgent.

The human instinct, as the field of?behavioral finance tells us, is to blame factors outside our control. When things are going well, we have no problem taking the credit, but when they don’t, most of us avoid blaming ourselves. Instead, we instinctively reach for stories about the stocks that are in the portfolio today, and why they are likely to make money in the future — we spin a narrative to inspire future hope, rather than dwell in the past.

But in this day and age, sophisticated investors are increasingly demanding more. Armed with data about fund holdings and risk exposures, they want narratives — not just about the future, but also about what’s been learned from the past — that are supported by evidence. Meanwhile, there’s no question that consumers (investors or otherwise) value both transparency and humility more today than ever before.

Investors don’t actually?want?to move assets from one manager to another, especially for performance reasons — the only winner there is the new manager they appoint. But like managers themselves, they have a fiduciary duty to make the best decisions they can, given the information available. If you don’t give them a solid enough set of reasons to stay with you, it’s their job to leave.

Managers who can explain, with clear, illustrative data, what they did well and poorly during a drawdown period have an advantage when it comes to retaining assets. Their narrative says something like, “Here’s me managing your money the way I said I would, and here’s what I can see I can do better in the future.”

Their secret weapon is?decision attribution analytics, which enable you to tell the story of your decision-making, in any market, based on the actual decisions you’ve taken. It’s about identifying skill (and opportunities for improvement) from a bottom-up perspective, as opposed to a top-down one.

For example, using decision attribution analysis, this manager is able to show her investors that while she was in the wrong stocks, during the period, her sizing and size adjusting decisions have been good ones:

It’s not possible for a manager to be in the right stocks across every time period. But it?is?possible for a manager to make consistently good sizing and size-adjusting decisions, regardless — that’s a matter of good process and strong discipline. The bonus is that having a strong process around sizing and size adjusting decisions frees up mental bandwidth to focus on getting the stock picks right more often.

All managers have the data required to do decision attribution analysis, but most don't. Those who have tried to do it themselves know it's harder than it sounds. But most haven't even tried. They, like their investors, use performance attribution and factor risk analysis as a feedback loop on skill. Those are great lenses for explaining where performance came from, but they don’t tell you anything about the investor’s actual decision-making, and what they could do differently on a go-forward basis, to get a better result.

As Joe Wiggins puts it in the inaugural?Decision Nerds podcast, “As an active asset manager, you’re selling edge and skill — that’s the thing you’re selling to the clients and customers. Yet you’re not showing any evidence of that thing … What [the investor is] buying is never actually presented to them.”

Decision attribution analysis enables a level of transparency and candor between manager and investor that just hasn’t been possible before. Does it magically correct historical underperformance? Of course not. But in a market like this one, investors are seeking openness, evidence-based understanding and a thoughtful plan for improvement, not past perfection.