There Is a Relationship Between Past Success and Future Returns After All

Essentia Analytics has found a link between a manager’s past skilled investment decisions — not performance — and higher relative returns in the future.


Illustration by II

A crack is growing in the language of the disclaimer stamped on every fund: past performance is not indicative of future returns.

New research shows that there is a statistically significant relationship between a portfolio manager’s past decision-making performance and future returns. Of course, returns that managers may have generated a year ago, still do not signal what they will deliver a year from now.

The research team at Essentia Analytics, which has made a business out of helping active portfolio managers get a handle on their behavioral biases and generate better returns, found that an equity portfolio manager who has made skilled decisions over the last year is 1.51 times more likely to outperform their benchmark than a manager who has not. Essentia will publish a report on the research on Thursday.

Clare Flynn Levy, founder and CEO of Essentia, says that this is the first time research has shown a statistically significant connection between a manager’s decisions — including identifying securities, sizing positions, timing when to buy, exiting, among others — and future returns.

The research simply backs up a concept that makes sense intuitively. Flynn Levy added, “Somebody who is skilled at decision-making, you’d think they would outperform.”

The findings are important to an industry once dominated by active managers who searched for securities that they believed would outperform the market. The problem for investors in that world was to find the best managers. This inability to identify top managers helped push investors to index funds that promise to match the returns of the market or some slice of it. But Flynn Levy and others have found that many active managers make plenty of good decisions, but flub others and face other barriers in delivering benchmark-beating returns. By analyzing detailed transaction data from active managers over time, Essentia Analytics has been able to highlight a manager’s strengths and weaknesses and help improve fund outcomes.

Essentia’s most recent findings are based on a study of information from its proprietary database on the daily holdings of 123 stock portfolios — on an anonymous basis — between 2014 and 2023. Using what it calls its Behavioral Alpha Benchmark methodology and which has been reviewed by peers and published in the Journal of Investing, Essentia analyzed the actual profits or losses that the portfolio manager created or destroyed with each decision. It then assigned a score to each manager, if there were at least 80 decisions to be vetted. A portfolio manager with a score greater than 50 is creating value; less than 50 and that manager is destroying value.

The average score across portfolio managers or teams didn’t predict future returns, which is what Essentia expected. But given that research by the firm in 2023 found that decision making skills do persist over time — why would a manager’s talent at sizing positions, say, randomly decline? — Essentia looked at the odds of high scoring managers in one year outperforming the following year. And the odds were high: managers with high scores were one and a half times more likely to outperform.

Flynn Levy said Essentia is continuing its research and she expects academics and other practitioners to follow up as well.

“It should prove true because it’s common sense. People are just jaded in this industry and they stopped asking the interesting questions and thinking with a half glass full perspective.”