The good news is that active investment managers are almost certainly better than ever.
The bad news is that it matters less and less.
Called “The Paradox of Skill” by Michael Mauboussin, head of global financial strategies at Credit Suisse, this is the idea that as the range of skills among players in a given game narrows, the relative importance in luck in determining outcomes rises.
In other words, as the poorer players get squeezed out, as they tend to over time, those with higher skills find fewer mistakes to exploit.
With outperformance from relative skill harder to come by, results driven by luck, which remains constant, become relatively more important.
Stephen Jay Gould, the late Harvard paleontologist and polymath, used this framework to explain why Ted Williams was the last batter in Major League Baseball to hit .400 over a season. He showed that the coefficient of variation in baseball statistical performance has declined steadily over the decades, something consistent with a better average standard of player and a steady supply of luck. In short: fewer bad pitchers to fatten one’s batting average.
As a (very) modestly skilled poker player, I saw this in action when poker first became popular online in Britain, where I was then living, about a decade ago. When the craze first took off, the pickings online were rich, especially on sites that attracted many players from Britain and Europe, many of whom were more recreational gamblers than experienced poker players. Over time, selection took place, with many bad players dropping out, or becoming better. Eventually it became harder to win, and lucky and unlucky runs of cards seemed, at least, to play a larger role.
As it was with poker online, so it has been in the investment world.
Mauboussin, building on work by Peter Bernstein from the 1990s, shows that statistical measures of outperformance by large capitalization mutual funds in the United States have been declining steadily for almost five decades, with the standard deviation of excess return now less than half what it was in the late 1960s.
Picking your game
That is consistent with an overall rise in skill among investors, not least because more investing is done by professionals. It would also be true, to the extent that you believe that skill is identifiable by those with capital, that the growth of hedge funds only reinforces the negative impact of this on investors. If investment outperformance is a zero sum game, and if hedge funds are better at this game, they will capture more of that investment alpha. As hedge fund managers capture more of the upside for themselves, by way of fees, the implication may be that the race toward skill has only made outperformance harder to come by in aggregate.
Mauboussin argues that under the circumstances, the key is to pick the right game in which to play. He offers a non-exhaustive list of three candidates: diversity breakdowns, institutions versus individuals, and trading with investors who are buying for reasons not to do with the fundamentals.
What he calls a diversity breakdown is when an unusually high number of market players is lined up on one side of a trade. These so-called crowded trades, for example the one personified in 2007 by the idea that US real estate prices could not fall sharply in every region simultaneously, can break down very rapidly and with huge jumps – or falls – in price. They can also go on so long that your clients abandon you and you lose faith in your own judgement, but that is why they can be so profitable.
Institutions vs. individuals is exactly as it sounds, essentially the search for markets, such as frontier emerging markets in which less-sophisticated and skilled investors play a relatively greater role.
The search for non-fundamental sellers is best personified by the popularity of estate sales, in which the heirs are seeking to liquidate not because that hedge trimmer has fallen in fundamental usefulness but because it now belongs to someone who will get less utility out of it.
In the corporate world, spin-offs are a good example. Since a proportion of the new owners of the spun-off company won’t want to bother doing the research on the spin-off, or won’t like its risk profile, the post-spin off price often represents a bargain to longer-term value.
For those of you either unsure of your place on the food chain or simply aware of how few investors beat the index when taking costs into account, the simple answer may be just to abandon active management altogether.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
