Measuring Professional Investor Decision-making Skill

Is detailed decision-making prowess a better metric than past performance for comparing portfolio managers? In their October 2024 paper entitled “Actions Speak Louder Than (Past) Performance: The Relationship Between Professional Investors’ Decision-Making Skill and Portfolio Returns”, Isaac Kelleher-Unger, Clare Levy and Chris Woodcock examine the link between professional investor decision-making and overall performance for long-only stock portfolios involving at least 80 decisions per year. Specifically, they analyze daily positions for each stock to quantify seven decision outcomes: stock-picking, entry timing, scaling in, size adjusting, weighting, scaling out and exit timing. They then aggregate effects of all decisions at the portfolio level relative to prospectus benchmarks or, where none is stated, to a relevant index. They measure added values of decision types as follows (see the figure below):

1. Stock picking – positive or negative overall return to the position while owned.
2. Entry timing – proximity of initial entry price to its low from 21 trading days before through 21 trading days after purchase.
3. Scaling in – comparison of return to a buy-and-hold strategy at average price of the stock from initial entry to first sell trade.
4. Adding/trimming/no-trade – comparison of return to buy-and-hold at the median quantity from first sell trade to the first sell trade after the last add trade.
5. Scaling out – comparison of return to a buy-and-hold strategy at average price of the stock from the first sell trade after the last add trade to the total exit.
6. Position weighting – comparison of return to that for a hypothetical equal-weighted portfolio.
7. Exit timing – proximity of final exit price to its high from 21 trading days before through 21 trading days after purchase.

They then combine hit rate (fraction of decisions with positive value-add) and payoff ratio (ratio of value-add to value-loss across all decisions)  for each investor to compute a Behavioral Alpha (BA) Score, and relate BA Score to current and future portfolio performance. Using proprietary daily holdings of 123 long-only stock portfolios managed by professional investors during 2013 through 2023, they find that:

(more…)