In my career, I have spent hundreds of hours with fund managers attempting to assess their investment approach. When I look back at this, aside from questioning my life choices, the one thing that strikes me is how little fund managers discuss skill. Of course, they talk about past performance (if it is good), but the randomness and chance in financial markets render this a terrible proxy. This is a puzzling situation, investors in active funds are seeking to identify and pay for skill, but the people managing them seem reticent to mention it.
It has always struck me as odd that in active fund selection, the onus falls heavily upon the allocator to strive to prove that the thing they are buying (skill) exists. Surely the seller of the product should be making that case?
Before exploring the reasons why investment skill is such a rarely discussed topic, it is worth defining terms. What exactly is skill?
Skill exists where we can see a repeatable link between process and outcomes (what we intend to do and the result of our action). We are often guilty of focusing on the second part of this equation – if the result is good, then some skill must be involved. This can be an effective shorthand if the activity is simple (shooting free throws in basketball) or heavily structured with limited randomness in the outcomes (playing chess). It is when things get noisy that the trouble starts.
In activities where the results combine luck and skill, focusing on outcomes alone can lead us astray. The greater the involvement of chance, the greater the need to understand the process that led to the outcome.
This is easier said than done. Focusing on process as much, if not more, than outcomes means retaining conviction and confidence even when headline performance is disappointing. Two things are critical here – time and belief. Extending our time horizon should tilt the balance in favour of skill over luck, but in order to have the required patience we must (continue to) believe that skill exists.
Imagine we have a biased coin that is likely to come up heads on 52% of flips. We should have more confidence in this edge becoming apparent the greater the sample size. To prove this advantage, we would rather see 10,000 flips than 10. We can think of this as akin to lengthening our time horizon. The problem is that if after 50 flips the coin has landed showing tails more often than heads, we might start to doubt that the coin is weighted at all.
Even if we possess an edge, we must often sit through periods when results make it look like we do not.
In investing, if skill exists, then it is difficult to identify and, if we do discover it, tough to benefit from. That does not mean we should ignore it. Asset managers are not only selling skill; they are paying people a great deal of money on the basis that they possess it. They should probably think about it more than they seem to.
Why don’t they?
– Past performance is everything: The industry is obsessed with past performance, and it is so ingrained in how it functions that trying to have nuanced conversations about skill might be deemed to be pointless. Strategies with strong past performance sell; trying to evidence skill does not.
– Stories sell better: Evidence of skill, which might be about the consistency of decision-making through time, is far less compelling and persuasive than captivating stories about an investment theme or star fund manager.
– Time horizons are just too short: As time horizons in asset management seem to become ever-shorter, the relevance of skill diminishes. Nobody operates with a time horizon long enough to even attempt to prove they are skilful.
– Too much complexity: Looking at past performance is easy, trying to define and evidence skill is complex and messy.
– Don’t want to know: Let’s assume some active fund managers – but not many – have skill, 20%, perhaps. If I am one of the majority, it is in my interest to actively avoid the question of skill. My odds of a lucrative career are much better relying on random performance fluctuations and trends.
There are many reasons why the notion of skill is rarely discussed in the asset management industry, and all parties are complicit in its neglect. The existence and persistence of skill, however, is the foundation of active fund management and it needs to be talked about more.
If it is being sold, it helps to know what it is.
My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).
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