Fund managers’ research firepower is now key to generating portfolio alpha, study shows

Investment research

The quality of research skills among hedge funds and other investment managers is closely tied to their ability to generate alpha in portfolios, a new deep-dive industry study has found.

Inalytics, a UK-based research outfit that aims to identify and benchmark investment skills for institutional investors, probed the connection between research capability and alpha generation using its database of 370 active equity portfolios and 26 fixed income credit portfolios.

The study split the portfolios into two groups: those with positive and those with negative alpha. It tracked opening buys – the first time a manager adds a new stock to the portfolio – to measure the effectiveness of the research process, since they are the “purest way” to evaluate managers’ research processes, according to Inalytics.

Those portfolios which generated a post-trade return for opening buys of more than 5 per cent were “virtually assured” of outperforming the market. Some 82 per cent of positive-alpha portfolios had opening buys that outperformed over the following year, compared to just 42 per cent for underperforming portfolios.

The study noted that 58 per cent of portfolios with positive alpha had a hit rate – the percentage of opening buy decisions that generate a positive post-trade relative return – of more than 50 per cent. That meant that 58 per cent of those portfolios got the majority of opening buy decisions correct.

In contrast, just 22 per cent among negative performers had a successful hit rate – a gap of more than two and a half times.

It also found that every additional 1 per cent relative return on opening buys was linked to a 34 basis points per annum increase in alpha.

Inalytics said the findings were consistent across portfolios, irrespective of geography, region, market capitalisation and style tilts, adding that a secondary study of 26 fixed income credit portfolios found similar results, “underlining the importance of research irrespective of asset class or market.”

Rick Di Mascio, CEO of Inalytics, said the results show a need for asset owners to understand and evaluate fund managers’ research processes as part of their due diligence and monitoring process, and the need for asset managers to develop a clear, consistent research process if they are to generate alpha.

The data also bring the importance of proprietary in-house research into sharp focus, he added, in light of “the relative demise of sell-side research.”

“These findings offer further evidence that research is at the foundation of the best investment processes and therefore at the core of any fund manager’s ability to generate alpha,” Di Mascio said.