Were Those Great Returns the Result of Skill — or Just Luck?

Spoiler: It wasn’t luck that gave Morgan Stanley Investment Management, Carmignac, Baird, and Invesco some of the top equity portfolios.

Illustration by II

Illustration by II

Knowing whether a manager generated double-digit returns because they were unusually brilliant — rather than simply lucky — could change how allocators choose the firms that invest their money. Essentia Analytics believes that it has found a way to do just that.

The firm recently tested 76 portfolio managers on the specific skills needed to produce strong investment returns. The assessment is the first of its kind and will allow investors to look beyond a manager’s historical performance and risk tolerance and determine how good their managers are at the real-world skills needed to produce strong future performance. Clare Flynn Levy, a former portfolio manager, founded Essentia as a way to use research from the field of behavioral finance to help active managers identify — and ultimately fix — behavior and skills that chip away at their alpha, a term used loosely to mean risk-adjusted returns that can’t be explained by the market or style premiums.

Essentia’s skill assessment methodology gets closer to providing an answer to one of the biggest unsolved problems facing the industry: How do you identify the best managers and separate their actual skill in producing great returns from luck? Past performance, despite ubiquitous disclaimers that it cannot predict future performance, is still a big part of the traditional approach to manager selection. But historical returns are essentially a scorecard that is subject to the random effects of luck. Of course, allocators also use a long list of other quantitative measures — including active share, which measures how different a fund is from a popular benchmark, and all sorts of risk ratios — to differentiate skill from luck.

But the new gauge, which Essentia calls the “Behavioral Alpha Benchmark,” focuses instead on the quality of a manager’s decision-making. Unlike a past track record, managers whose skills have led to success in the past can use those skills again in the future.

In a new research paper to be released on Thursday, Essentia used the new benchmark to evaluate 76 anonymized active, long-only equity portfolio managers over a 36-month period ending on March 30, 2022. The study only includes managers who are also Essentia clients, because researchers otherwise would have needed years of detailed, publicly unavailable data on trades and other decisions made by thousands of managers operating worldwide. Nevertheless, the results have helped create a new picture of what a skillful manager actually looks like, information that could change behavior in the industry.


The Behavioral Alpha Benchmark incorporates Essentia’s seven key decision types: stock picking, entry timing, sizing, scaling in, size adjusting, scaling out, and exit timing. Essentia looks at each decision type and measures the impact that a manager has on a portfolio: In the end, did he or she add value, or destroy it?

While the decisions of the 76 managers were aggregated and studied anonymously, Essentia Analytics did disclose (with permission) the top five portfolio managers based on the level of skill in each decision: Vishal Gupta, Morgan Stanley Investment Management’s Emerging Markets Leaders’ fund; Mark Denham, Carmignac’s Portfolio Grande Europe; Jonathan Good, Baird’s Small/Mid-Cap Growth fund; Xavier Hovasse and Haiyan Li-Labbé, Carmignac’s Emergents Fund, and Martin Walker, Invesco’s U.K. Opportunities Fund.

One of the most surprising findings is that managers get their decisions wrong most of the time. When Essentia evaluated the many different types of decisions that managers make during the life cycle of an investment, they found that only 18 percent of the respondents to the firm’s survey had a “hit rate” — a decision that added value — above 50 percent. In fact, what Essentia called the “most-right” manager was accurate only 55 percent of the time. While that may sound low — after all, few would accept a doctor who was right only half the time — many legendary portfolio managers probably wouldn’t find it surprising. Fidelity Investments’ Peter Lynch, for example, famously said that he’s wrong most of the time, but that when he gets it right, those winners make up for the long list of losers.

That’s in line with what Essentia found in its groundbreaking study: When managers were spot on, it was by a wide margin. Sixty-eight percent of the managers surveyed delivered more value when they got a decision right than they lost when they got it wrong.

Flynn Levy explained the luck versus skill conundrum this way: “a good decision is one that produces a more positive outcome — on average — than would have been achieved by chance. If an investor consistently makes more good decisions than bad, and their good decisions consistently add more value than their bad decisions destroy, then over time this investor should perform better than someone for whom this is not the case. Whatever the influence of luck on their historical returns, this manager has shown evidence of possessing true skill.”

Chris Woodcock, chief product officer, added, “Performance is a noisy statistic. It’s a function of luck and skill, and the luck part is big. Right now managers show allocators the outcome and then everybody tries to reverse engineer what happened. What we’re trying to do is novel: make it possible for both allocators and managers to look at the same things. it’s about decision quality.”

In a finding that should be heartening to most investors, the research and analytics firm also found that 58 percent of portfolio managers added value through their stock-picking decisions. But a majority of managers destroyed potential returns by making poor decisions when sizing a position. Only 38 percent of the 76 managers added value when determining how big a position should be.

Managers are also weak sellers. “What was notable was that three-quarters of managers were destroying value through scaling out, basically selling. And that’s not just the day you sold the last share, but the whole window, how fast you reduced to zero. Not a lot of thought goes into that. Managers are more focused on entry. As a result, you end up wasting alpha in the way you get out,” said Flynn Levy.