Behavioural analysis has the potential to transform the way funds are managed. This is no idle claim. It is an approach to trading and money management which is likely to see take-up across the managed funds business in the next few years. One of the pioneers in this sector is Taras Chaban, CEO at Investment Intelligence and winner of The Hedge Fund Journal’s award for Innovative Analytics Software (Behavioural Science). The Investment Intelligence Edge software product has been launched to help portfolio managers and CIOs improve the way they make money management decisions. It achieves this by delivering a better understanding of behavioural patterns and promoting deliberate learning from past decisions and overall improvement in performance, in a way similar to the analysis of the performance of elite athletes in the sporting world. CIOs, investors and company management receive a much deeper understanding of what drives the performance of fund managers.
Like many other award-winning software packages, Edge has a predecessor that was developed and road-tested in a live environment, in this case inside hedge fund GLG Partners. Edge takes a scientific approach to the evaluation of individual performance, already commonplace in the world of professional sport, but still sadly lacking in the fund management space.
The investment management industry has always been performance-oriented, and in such a statistically rich environment, it should be possible to see quite clearly from their results which portfolio managers are good, and which have room to improve. But Chaban argues this is just a top-level view, and to really understand results, investors and fund managers should be looking deeper.
“A lot more can be done in the analysis of fund managers themselves,” he says. “Currently many traders and investors can only refer to handwritten notes if they want to analyse their own performance. They are beginning to replace this with spreadsheets, but it is important to understand that when it comes to analysing bets, human memory is not reliable. Investors can lie to themselves sometimes without realising they are doing it.”
The critical point he is making is that only by religiously tracking the decision-making process in a dynamic environment is the fund manager going to build a better picture of why he succeeds and why he fails. “Know thyself,” advised the ancient Greeks. Work out what you are doing wrong, sometimes when it is not immediately obvious, and then you can get better. In a business where every basis point of investment performance is critical, this takes on new significance.
How does it work?
Behavioural analysis begins by systematically recording the money manager’s thought processes. This includes recording the broad number series – like the manager’s success rate, capital allocation, and any other rules applied (e.g., risk management). Edge takes these numbers and adds other considerations like position sizing and external signals to generate a picture of how good a manager is at picking stocks.
Edge uses a modular approach, assessing historical data and the current portfolio and highlighting correlations with historic decisions. Are there any habits or patterns emerging that the investment manager is now aware of? What is informing those patterns? The key is to isolate the profit/loss record from outside influences like a risk management policy, or UCITS liquidity requirements, for example, in order to drill down into the fund manager’s behaviour.
“Our software can help to illustrate what is optimal, and what is sub-optimal,” says Chaban. “What is the likely outcome based on past calls? From this we can also determine the likely outcome based on the current portfolio.”
One of the key arguments a behavioural program like Edge is making is that, even for profitable fund managers, it is possible that some degree of returns is being given away through unnecessary habits and poor decision making. Is the manager holding on to a trade too long after the price peak, for example? Are some shorting opportunities being missed? Is enough leverage being used?
There is no ‘right’ way to approach behavioural analysis. Much of it will be informed by what the end client is seeking to find out. Investment Intelligence realise fund managers are going to want to slice and dice performance in many different ways. Hence, the company have programmed their systems to be highly configurable. Clients can establish their own check list of performance information they wish to analyse, although he is obviously able to provide advice on what some of these parameters might be if the client is starting from scratch.
“The importance is to understand high-conviction ideas,” he says. “You must have some checks in place. This makes it easier to be less emotional when it comes to analysing results.”
While there are applications for self-analysis by the single manager fund, it is also obvious that multi-manager funds and indeed the larger multi-fund complexes overseen by mature hedge fund groups will benefit from behavioural analysis. Edge allows the CIO a high degree of look-through to the results of his fund managers, using historic data where it is available to see what improvements could be made to style and decision making. Once installed, fund management teams can access the same system and adhere to a standardised check list, allowing their performance to be benchmarked to the same criteria where required. This brings an entirely new layer for discussion in meetings of the portfolio management team: CIOs may start to wonder how they got by without it.
Keeping a diary
Edge’s journaling capabilities are also an essential part of the process, as this allows other members of the organisation to see why investments were made or avoided. By rigorously including the arguments for or against trades, investment managers can benefit from a much deeper perspective on their entire allocation process. CIOs can carry this forward to assessing the investment ideas generated by in-house analysts in order to be able to remunerate their team more effectively and to groom future portfolio management talent internally. Its utility as a fund manager training tool is obvious.
Edge can add value to strategies where there is a decision-making process. Tried and tested on equity-based funds it is perhaps of most use in this space, although it also works with clients that manage non-equity funds.
Delivery is via a front-end web solution allowing clients to log into their personalised analytics suite from anywhere in the world. The software can also be installed and managed on internal servers if required. The company offers flexible pricing and licensing plans according to clients’ specific needs and circumstances. Additional features include the generation of PDFs and data to support marketing efforts.
Beyond its applications for the portfolio manager, it is obvious that some investors will want to use Edge to help with monitoring portfolios where they enjoy 100% transparency, for example via a managed account. It can provide an additional layer of analysis on why funds make or lose money.
As a compliance tool
Recent events of insider trading in the US like the Galleon case have drawn attention to the fact that hedge fund managers need to become much more disciplined when recording why they took the decision to open or close a particular position. Detailed regulatory investigation can mean that each trade will come under scrutiny. The provision of an independently verified trade journal can be invaluable under such circumstances.
To this end Investment Intelligence has launched Compass, a separate software product designed more forits compliance and oversight capabilities than performance analysis. It lets a compliance desk analyse in detail why fund managers made a particular trade and the context surrounding those decisions. Using fund manager-specific behavioural profiles, it lets the user evaluate and score potential insider trades. This systematic approach to scoring avoids human errors and provides a strong audit trail, in turn enhancing reporting to the regulator.
Regular trade journals mean that a pattern supporting buying decisions can be established, and compliance personnel can determine whether trading decisions during periods of unusual market activity remain consistent with that pattern. Much of the functionality is based on the estimation of probabilities and the systematic evaluation of the likelihood that a trade is an insider trade. Ultimately, the final call is down to the compliance team.
"Compass is a system that provides compliance personnel with the necessary tools to evaluate trading activity. It uses behavioural scoring which reduces the number of false positives and relies on a compliance person to have a final sign off on the flagged trades" says Chaban. “You still need a compliance person sitting at the end of it. But big or small, funds are going to have to report in more detail going forwards. They will have to have a process, and compliance officers will need to demonstrate they have this process in place in order to meet the requirements of the Market Abuse Directive.”
Compass – and Edge – are passive as well as active systems. Diarising can be carried out whether a final investment is made or not. This provides an important reference library for trading behaviour, as the invaluable ‘look back’ capability this offers helps to analyse overall behavioural patterns. Just because you decided not to invest, does not mean that your reasons for not doing so can’t help to inform your decisions next time around.
Security is always going to be an issue for hedge funds, and the information tracked and stored by both Edge and Compass is considered of critical importance to investment managers. Hence, it is no surprise that Investment Intelligence is able to deliver secure hosting and access procedures for those firms who want it. Investment Intelligence say it boils down to how much security a client requires, but he regularly works with specialists in the secure hosting space who can provide options for this. Other clients have chosen to host Edge internally under their own data security umbrellas.
As with all successful software products, Investment Intelligence software range does not stand still, and is subject to an ongoing development process which is frequently informed by client feedback. “We are very much client-driven,” says Chaban.
Investment Intelligence uses this feedback to help it to tailor the application to meet the changing demands of the industry it serves, and those demands look set to increasingly incorporate the behavioural insights the firm can readily offer.