The difference between skilled and lucky investment managers is that over extended periods, skill should prevail in delivering good investment outcomes, while luck can only persist for so long before it becomes undone. It is important to distinguish between the two and to focus on the right factors when choosing an investment manager. Vuyo Nogantshi discusses some important aspects to consider when making your decision.
Michael Mauboussin, a well-known contributor to the pool of literature on skill in investing, characterises investing as an activity that sits somewhere on the spectrum between pure skill (no luck) and pure luck (no skill). If you think about activities that require skill and those that require luck, a key aspect to focus on is intention.
If you can deliberately drive the outcome of the activity and repeat this, then more skill is involved. For example, consider chess, where it is considerably less likely that a grandmaster is luckily outdone over the course of a game.
Is past performance the only means to assess skill?
Past performance is a good means of assessing manager skill. This is especially the case when you measure performance over a longer period and over many investment cycles. Less weight should be put on short-term measures as this can be misleading. However, even longer-term performance has its pitfalls and as an investor, you must be cognisant of the perils that exist in basing conclusions solely on this factor. Performance can be distorted by things such as 1) appropriate benchmarks, 2) the opportunity to outperform, 3) how the investment is constrained, and 4) market factors.
A benchmark is a point of comparison. Investment managers set benchmarks to measure the performance of their funds. While benchmark selection is complex – and we cannot go into the detail in this piece – a benchmark should be appropriate to the nature and form of the investor’s objective.
For instance, while Everton F.C. is an English Premier League football team, it makes little sense to benchmark Real Madrid C.F. against Everton. However, if we did choose to go ahead and benchmark in this way, we would not be able to tell much from the result, other than to say that Real Madrid was able to beat Everton. In order to assess how good Real Madrid is, we would need to position an opponent that was representative of skill against Real Madrid and assess how consistent their performance was over time.
Similarly, for manager performance, if the benchmark set is not appropriate, it can appear as if a manager has skill, when in fact the true conclusion to be made is that the benchmark selection was poor.
The opportunity to outperform
Debate on active versus passive investing generally focuses on the concept of the zero-sum game (active investors in aggregate earn the same average return, before fees, as passive), but another important factor is whether the opportunity for active management to “work” exists.
One indicative lens used to assess the state of a market is “cross-sectional volatility”. This measure tests whether stocks in a market are moving together or diverging. For opportunities for outperformance to exist for an active manager, the market should be diverging (i.e. a higher cross-sectional volatility measure). This measure is a good tool (among others) to assess whether the environment structurally allows your active manager to add value.
Bear in mind that different markets present different opportunities for outperformance (alpha) and that this will impact the performance signature of investment managers in those markets. This is why it is important to assess performance over time.
How are different investment managers constrained?
Investors tend to see two sets of performance from two different portfolios and immediately draw conclusions about the superiority of one over the other. But beware of “comparing apples with pears” (or “grandmothers with toads”, as the Serbian saying goes). Without clear knowledge of what constrains each portfolio (e.g. offshore allowance, asset allocation limits, mandate limits), some conclusions may be questionable. Make sure that your comparisons are fair.
The history of South Africa’s stock markets is not complete without a discussion about the dominance of certain sectors and large shares over time. As Ruan Stander discusses, Naspers currently dominates the market, representing over 20% of the top 40 shares in issue, while previously, the conversation focused on the resources sector. Situations such as these can distort investment outcomes since managers could simply be winners or losers by holding or not holding a dominant share. When assessing performance, you need to ensure that performance was not the result of a single big bet.
What other factors point to a skilled manager?
It’s important to know and understand your manager and consider qualitative measures, such as the trusted Ps: philosophy, process and people. This will allow you a better sense of their intention and the subsequent outcome, which in turn will allow you to better judge skill over luck.
The philosophy is how an investment manager thinks about investments and how they invest. If you understand your manager’s philosophy, you should also be able to understand their decisions. But investment philosophies are only as good as their application. It is important to assess your manager’s behaviour relative to their philosophy through several market cycles.
Process is how the investment philosophy is implemented in client portfolios. A well-worded philosophy has very little value if it is not backed by a robust process that guarantees that positive outcomes can be repeated. A weak process is one indicator of the lack of skill involved.
Investment management is a business of people – the third P. Having the right people with the necessary experience is crucial for the implementation of the philosophy and process.
Lastly, remember that investment outcomes are the translation of your manager’s intentions into a balance of wins and losses. What you need is for those wins to outweigh the losses to deliver outperformance. Better understanding managers’ track records, processes, philosophies and people will give you a better sense of which managers are more dependent on skill and which are more dependent on luck.