When we succeed, it’s human nature to want to take the credit. Say we smash an exam, land a top job or win an award, we like to put it down to our own innate talent or hard work. The uncomfortable truth is that factors outside our control, including just plain luck, play a much bigger part than we care to admit.
It’s easier to distinguish luck from effort and skill in some cases than others. Take the recent Olympics, for instance. It was clear by her early teens that Keely Hodgkinson was a hugely talented athlete. She trained for the 800 metres in Paris six days a week after finishing second in Tokyo. Once there, she remained focused and executed her race plan perfectly, and thoroughly deserved her gold medal.
But there were many examples at the Olympics of external factors affecting outcomes. Fortune smiled, for instance, on athletes allocated rooms with air conditioning; on runners who benefited from strong tailwinds in their heats; on rowers randomly assigned lanes that gave them a slight advantage; and on equestrians who drew the horses best suited to course conditions. Bad luck played a part too, as any of the triathletes who fell ill from swimming in the Seine can attest.
Evidence for skill among active managers
In some areas it’s very much harder to gauge the role of random chance. Active investing is a classic example. Several studies have shown that outperformance by active fund managers is largely attributable to luck rather than evidence of superior skill.
In 1968, for example, Harvard professor Michael C. Jensen found that very few managers produced positive alpha persistently enough to indicate skill. The majority underperformed the market on a risk-adjusted basis, and the dispersion of returns was consistent with what one would expect from random chance.
Eugene Fama and Kenneth French addressed the same issue in 2010 and came to similar conclusions. A small fraction of the managers they looked at did appear to achieve returns that were not merely due to luck. Those managers were, however, even fewer in number than would be expected by chance alone.
A crucial fact that many investors fail to appreciate is just how many funds there are at one time that they can invest in. There is such a vast array of choices that it’s virtually guaranteed there will always be funds which have produced remarkable returns in the recent past.
Genuine skill should be repeatable
The key, as Jensen identified in the 1960s, is whether a fund can outperform persistently. As the Persistence Scorecards produced by the S&P Dow Jones Indices show us time and again, very few managers are able to beat the market for more than a few years at a time.
As Craig Lazzara, who developed the S&P scorecards, explains: “Results produced by genuine skill are likely to continue, while those due to luck are likely to prove ephemeral. The data suggest that good active performance often owes more to luck than to skill.”
As you can imagine, fund managers themselves can be very sensitive to suggestions that outperformance is primarily down to luck. As David Jones, Head of the UK and Ireland Advisor Group at Dimensional Group, explained in a recent article, it’s no surprise that they feel that way.
“Just like Tiger Woods getting on the green,” he wrote, “(outperformance) is, after all, what they are aiming for. And, having enjoyed the financial rewards and elevated social status that accrue from a successful track record, they are hardly going to be incentivised to admit to their investors that, at the end of the day, they just got lucky.”
The paradox of skill
There is, however, a very important point to make. Yes, the overwhelming evidence is that outperformance owes more to luck than skill, but that’s certainly not to say that fund managers aren’t intelligent or that they don’t work hard enough. In my experience, most are very smart, conscientious and highly motivated individuals.
The problem is that, in active management, it’s the relative level of skill that is more important in determining outcomes, not the absolute level. When the aggregate skill level rises, the role of luck becomes even more important — a concept referred to as the “paradox of skill”.
Over the last few decades, the investing industry has grown almost exponentially in size. As Charles Ellis wrote in a 2014 issue of the Financial Analysts Journal: “Increasing numbers of highly talented young investment professionals have entered the competition. They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”
The “unsurprising result” of this increase in skill and resources, Ellis says, is that modern stock markets have become more efficient, which “makes it harder to match them and much harder to beat them, particularly after covering costs and fees”.
It is, in other words, no disgrace for an active manager to lag the market. In the long run, it’s extremely hard to beat it — at least not without a large degree of good fortune.
That, of course, is no reason to carry on using actively managed funds. To use Ellis’s famous phrase, active management is a loser’s game, and, unlike the Olympic 800 metres, winning is largely down to luck. Sooner or later your luck is almost bound to run out.
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HAVE YOU READ THIS BOOK?
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