Assess whether an investment manager's results reflect genuine skill
The idea
Skill means value added that is repeatable and not explained by luck or by exposures a cheap index could supply. Start with appraisal: alpha and the information ratio measured against the correct benchmark. Test significance: the t-statistic of active return is about IR × the square root of the number of years (annualised IR, returns independent over time), so a manager with an information ratio of 0.5 needs roughly (2 ÷ 0.5)² = 16 years of data to reach t = 2. Then check that attribution shows gains where the manager claims an edge, for example selection for a stock picker rather than allocation or factor tilts, and that results persist across periods. Combine this with qualitative evidence about philosophy, people and process. The trap is inferring skill from a short, strong record.
Formulas
Is the record long enough to show skill?
t ≈ IR × √T
- t
- the t-statistic of the active return
- IR
- the annualised information ratio: active return ÷ active risk
- T
- the number of years of returns
A t of about 2 is the usual bar, so the years needed are roughly (2 ÷ IR)². At an information ratio of 0.5 that is 16 years, which is why a short, strong record says little about skill.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Portfolio Performance Evaluation
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