How to spot a star fund manager

6th June 2012

The investment card trick – taking the luck out of the draw

Find a fund manager that beaten the lights out of the index and the competition for three decades. That means he (statistically virtually certain to be a male) has beaten thousands of other managers over that time. The others have all fallen for one reason or another – they might have retired, been fired or seen their funds consolidated with others.

Now take that fund away from our super-manager. Give it to someone else. And move our first  manager to a new investment vehicle. What will happen? Will luck or skill or neither prevail? Will he continue with his success in the new fund? Will the replacement do well? And what would occur if the assets change?

Working through and understanding the complex relationship between skill and luck is one of the most important tools in the investor's armoury. It enables institutions and individual fund purchasers to decode marketing material and demystify presentations.

Skill and luck in front of goal

Skill and luck are most clearly seen in sport. We know it when we see it. If a footballer shoots a ball from way out past defenders and goalkeeper, that's skill. If the shot looks wide but hits an opponent who suddenly runs in and scores an own goal, that's luck.

And sometimes, it what we don't see that counts. It takes skill to throw a game. An activity where it is impossible to lose on purpose is driven by luck – for instance whether a pack of cards opened at random displays a red or black suit.

Skill is lasting. Luck reverts to the mean so the red/black card distribution will eventually turn out fifty/fifty. Any activity based on luck such as a blindfolded person picking shares with a pin will turn out to be average. The reason why it might produce better than midway results in fund management is because the pin-picker works for nothing while professional fund managers take fees out of the equation.

Needing a long run of results

US academic and fund manager Michael J Mauboussin believes investors should understand the mix of luck and skill that determines business and financial decisions. That may need a long run of results – no one would look at the Premiership after each team has played just two matches to determine the outcome for the season.

He says the key is to understand the relevant time period. A high frequency trading system can be judged more rapidly than a strategy based on holding stocks for five years.

The ratio of skill to luck determines how quickly a winner reverts to average. Take a fund manager who does well over eight discrete quarter-year periods. If he or she continues to beat the competition over more three month periods, then this is probably skill. But if year three shows a fall-off, and by year four, there is a reversion to the average, then this is probably good and bad luck, not ability.

Fund groups have a selection of excuses to deal with declining results. They may blame it on changing investment style – value replacing growth, for instance – or on a differing volatility appetite or on a refusal to be swallowed up in the latest craze (such as a bubble economy).

But for investors, the most important reason for understanding the skill/luck continuum is that it helps understand not where a participant ranks but why. This is not as clear in fund management leagues where there are many participants in complex relationships as it would be in a one-on-one activity such as judo.

The problem with funds and less complex assets is that investors can only look at outcomes by which time it is too late to make the decision. In boxing, you can assess skill and other non-luck factors beforehand – you know that a trained heavyweight is likely to defeat a good lightweight.

Useful hints to spot skill rather than luck

Mauboussin believes investors and investment managers can reduce the role of luck and increase that of skill in a number of ways.

Finally, here's a way of telling if skills among a group of competitors have increased or not. Look at the gap between the best decile and the worst decile (or any similar statistical comparison). If that narrows or if both, over time, start to revert to the mean, then overall skill is taking over from luck. And if a fund manager does well in skill-driven environment, it could mean that she or he is the one who will provide long term above average returns. 


More on Mindful Money:

The sins of high frequency trading

Decoding share prices

Can the financial system be fixed? The Philosopher vs the Trader

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