The failure of active managers to beat passive strategies has been pinned on everything from the real-time and widespread availability of valuable corporate data to complex market structure dynamics.
But new research shows that active management’s biggest challenge may come down to human nature and behavioral mistakes. Human nature is a complex problem, but behavioral mistakes can be fixed.
Essentia Analytics, a data analytics company based on behavioral science, is attempting to correct behavioral mistakes by sending portfolio managers simple but customized messages, called nudges, asking them to do things like take a second look at a growing position. Essentia found that portfolio managers who engaged with the nudges outperformed their benchmarks by 1.6 percentage points on an annualized basis, compared to those who did not pay attention to the messages. Essentia analyzed 75 equity portfolios and 15,000 nudges sent to real portfolio managers between mid-2018 and March 2021.
According to Clare Flynn Levy, who founded Essentia Analytics after a career as a portfolio manager, nudges can be anything from an alert on potentially vulnerable positions to notifications that a holding could be at or near what the firm believes is the peak of excess returns. These nudges are sent to portfolio managers when Essentia finds key patterns or indicators that could impact trading performance.
“Nudges help you keep your eye on the ball,” she said. “They help you focus on the things that matter.”
Speaking to Institutional Investor, Flynn Levy explained that nudges grew out of behavioral psychologists’ work on what they call the mere measurement effect. “The act of being asked a question about our intention or anticipated regret changes our behavior,” she said.
Keeping Portfolio Managers “Intellectually Honest”
Essentia sends two different types of nudges. One is triggered by a manager buying a new stock. The nudge asks the manager about his or her intention, tailored to what that manager values, such as cash flow or macro characteristics. “The nudge might ask, ‘How will you know you’re wrong?’ — things that force you to do a pre-mortem of the idea,” she said. Flynn Levy said these messages force people to be intellectually honest about their decisions, rather than just create a narrative or story after the fact, something that humans naturally do about everything in their lives.
The second type of nudge is triggered by activities in the portfolio, such as a position reaching a two-year anniversary. Based on years of data analysis on the manager’s portfolio, Essentia can send messages alerting managers to a point in time when the alpha of previous positions started to erode. “When does alpha start to conk out?” Flynn Levy said. “We’re not telling anybody when to sell. But we’re saying it might be worth checking in with the position.”
For the study of how nudges impacted performance, engagement could mean answering just one message. Even portfolio managers who responded to one incoming nudge saw gains. To quantify how much nudging enhanced performance, Essentia compared the simple median performance of the fund managers who engaged with nudges to those who didn’t.
Essentia also measured the level of engagement and found that managers who answered more messages outperformed by an even wider margin. The data analytics firm found that on average, every monthly response by a manager to a nudge correlated to an additional 18 basis points of alpha per year.
“There are lots of fund managers in the market who would say that they find alpha in other people’s biased behavior,” Flynn Levy said. “But why not worry about yourself? You can control only one thing in this world, which is your own behavior. It’s so much easier than trying to grapple with the market, which is changing all the time or trying to predict what the market is going to do next.”