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Tapping the Power of Advanced Behavioral Analytics to Generate Alpha

Human bias in investment decisions has long eroded alpha. Finally, new analytical capabilities can quantify this factor and give institutional investors powerful performance advantages.

Economists have known for generations that natural cognitive biases – including loss aversion, herding and confirmation bias – are pervasive forces in influencing investment decisions and creating sometimes poor (or, at best, sub-optimal) outcomes. But simply knowing about these biases is of limited use. To fight their influence, investors need to identify them and use targeted strategies to overcome them in the day-to-day moments when they occur. Doing this effectively hasn’t been feasible until recent years, when advances in data science finally made sophisticated analytical capabilities accessible to institutional investors.

Now unleashed, the performance advantage that modern behavioral analytics offers is quickly creating a new imperative for the investment industry, according to Paul Fahey, head of Investment Data Science for Northern Trust and Clare Flynn Levy, founder and chief executive of Essentia Analytics, a leading company in behavioral analytics. We spoke with them about how institutional investors can tap the power of behavioral analysis to improve investment outcomes.

Northern Trust just took an equity stake in Essentia. What drove that decision?

Paul Fahey: It’s in line with our strategy of directly supporting the front office and portfolio managers. We want to enable them to continuously improve their process and enhance their ability to generate positive outcomes. Additionally, we saw the opportunity to provide asset owners with better tools to support their stakeholders and really work alongside their managers, to drive better returns – either through the initial due diligence phase with their managers or the ongoing oversight of them.

Clare Flynn Levy: From Essentia’s point of view, it’s a great fit as Northern Trust is already the custodian of a vast amount of asset managers’ data – and is in a prime position to leverage that data and serve those clients far beyond accounting and settlement. We’re excited to work with them to bring our services to a much larger audience.

Clare Flynn Levy

In bringing behavioral analytics into the picture, what new capabilities does Essentia add to Northern Trust’s investment data science strategy?

Paul Fahey: Our Essentia partnership changes the game and the conversation for both asset managers and asset owners. Our asset manager clients are getting better access to more data, more quickly, that identifies where they are creating and destroying alpha. And, importantly, it tells them how to address that. It also helps in communication with their clients because they don’t need to rely on anecdotal evidence when queried about how they drove value for their investors. They can show evidence-driven decisions.

For asset owners, behavioral analytics allow them to have more intelligent conversations with their managers – and then, in turn, better internal conversations with their committees and stakeholders. They, too, no longer need to rely on anecdotal evidence as to why a manager outperformed or underperformed. This helps with manager selection, naturally, and allows allocators to make the case that they’re choosing managers that are delivering.

With this game-changing technology, the ultimate beneficiary is the capital owner, whether it’s the retail investor, or stakeholders for asset owners, endowments, foundations, public funds, corporate pensions, and so on.

Clare Flynn Levy: I’m a former fund manager and I started Essentia to solve a problem – which was a lack of visibility into exactly which types of decisions I was making well and those I was consistently getting wrong. Fund managers want to maximize their return on energy expended, but they haven’t had the means to do that efficiently, until now. Essentia can provide new visibility into what’s working and not working in their investment process. And we can help them make measurably better investment decisions, which has a huge knock-on effect to the business.

Since they started working with us, the average Essentia client has improved performance by 150 basis points per year of excess return. If you do that every year, that’s the difference between being in the middle of the pack and the top. Essentia enables Northern Trust to deliver that value-add to their clients.

Paul Fahey Quote

Are technology advances allowing conversations about behavioral analytics that were impossible just a decade ago?

Clare Flynn Levy: Yes. Until recently, there weren’t behavioral analytics to speak of in the investment management industry. Institutional investors and managers only had performance attribution analysis as a feedback loop on a manager’s skill.

It’s a bit like the analysis in professional sports before the Moneyball approach came along. There was some analysis with people trying to predict who was going to win, based on who won in the past, but it was very imprecise and wasn’t really helping anybody win more games in ways you could prove. Then Moneyball came along and changed all of that.

That’s what modern behavioral analytics is doing for investment management. It’s enabling managers to understand clearly which types of decisions they make well and which they make poorly. Their job is to make decisions just like a baseball player’s job is to hit a ball. But there are different pitches, different situations, and so forth. You need to know where’s your sweet spot and where do you swing and miss? Once you learn that, you can lean into it or improve it. And when you start measuring the impact, that is completely transformative.

Paul Fahey: The Moneyball analogy leads to a question: If we’re applying this level of technology and data science to sports, shouldn’t we apply it to the retirement outcomes for hundreds of millions of people? I think that’s our moral obligation, as an industry.

Are some managers uneasy about exposing where they miss the mark regularly?

Clare Flynn Levy: Interestingly, the managers we work with are open with their investors about what they’re learning. They’re armed with facts in ways they haven’t been before, generated by an independent third party who are experts in this field. They’re having more transparent, meaningful conversations with their asset owners than ever before. Everyone involved is a winner, and it’s consistent with the trend in transparency that is inevitable in this industry. The manager wants to have honest, transparent conversations with their investor, because this is a partnership and a trust relationship. Before behavioral analytics, they just haven’t been armed with information to do that in any consistent way.

Paul Fahey: I agree, the manager wants those conversations to be transparent, and the investor clearly wants a transparent view of the manager’s performance and what they’ve done. But beyond that, we’re at the point now where investors are beginning to have access to the same sophisticated data, so it’s an imperative. The manager should meet the investor where they are and have that conversation. The alternative is, they are a victim of the data and information that the investor already has in picking apart their performance. So there is a genuine interest from both parties to have that open dialogue.

Can you offer a specific example of how modern behavioral analytics has improved alpha?

Clare Flynn Levy: I have many examples. We recently published a case study on work we’re doing with a Dutch asset manager called NN Investment Partners, which was acquired by Goldman Sachs Asset Management last year. We’ve been working with them for about three years now. In this case, it was for their Eurozone high-dividend value fund.

As we always do, we started by analyzing their entire trade history and looking at every decision they ever made that resulted in a trade. Then we go further; there are a lot of decisions that don’t result in a trade, and nobody’s capturing that data until they start working with Essentia. We combine all this information and look for patterns. Going back to the Moneyball analogy, we analyze every game you ever played and then we zoom in on every pitch, every hit, every play.

For this fund, three powerful patterns emerged. One was a strong loss aversion bias, which we see a lot. It’s a reluctance to exit positions as they’re falling, because, as human beings, we don’t want to take the loss. We created a weekly notification, called a nudge, telling them when they are exhibiting this behavior. This has been extremely powerful for NN Investment Partners; the fund’s performance has improved by 180 basis points since they’ve started working with Essentia.

Paul Fahey: Identifying loss aversion is critical because investors don’t have a good grasp on where they’re tying up capital in losers. If they did, they would pull capital out earlier to preserve some of the alpha they’ve generated and redeploy it into more lucrative investments. But without that analysis, they just continue doing what they’ve always done.

Are there misconceptions that even sophisticated institutional investors have about behavioral analytics?

Clare Flynn Levy: Some investors may say, “I’m afraid that this analysis is going to mess with my process.” Most of us are programmed to embrace the status quo. Yet if you look around, you must change your process. The times have changed, tools have changed, your competition and the market have changed. Essentia can help you really get precise about making the right changes at the right times. But that doesn’t mean you throw away your philosophy; we help you find ways to improve your process and outperform – while staying true to your underlying philosophy.

Paul Fahey: If behavioral analytics was a question of just grading everyone’s work with a red pen, that would probably not go far. But it’s highlighting where the challenges are, and then providing users with tools and asking, “Okay, how do we get that C- to an A+?”.

Clare Flynn Levy: And from a fund manager’s point of view, that is unprecedented. Everyone is constantly judging the managers, but this is about empowering them with new information to improve. That’s the difference.

At this point, where are we in the adoption of advanced behavioral analytics in the investment industry?

Clare Flynn Levy: It’s still among early adopters, but it’s growing quickly for all the reasons we’ve mentioned. A demographic shift is a big driver; the younger fund managers coming up have been using advanced data science for many years and behavioral analytics isn’t scary for them. It’s table stakes.

Paul Fahey: This is an important point. Digital natives not only want this analysis, they are demanding it. It’s table stakes for them, as Clare said. I think we’re going to see an acceleration in adoption of behavioral analytics in the next 12 to 24 months and, frankly, intuition” may very well become a dirty word.

Again, it bears repeating that this analysis is becoming an imperative. Ignoring it is just not an option. If you’re an investment manager, you’re going to face tough questions regarding behavioral analytics from the investor. If you’re an investor, you’ll need to answer tough questions from your stakeholders, investment committees, retirees and so on. So whatever side you’re on, you cannot avoid engaging with advanced behavioral analytics if you truly want to do right by your stakeholders. At some point soon, you’re either going to benefit from its use or fall victim to it.

Learn more about using advanced behavioral analytics to generate alpha

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