Index Funds and the Paradox of Skill

“Gifted, determined, ambitious professionals have come into investment management in such large numbers during the past 30 years that it may no longer be feasible for any of them to profit from the errors of all the other sufficiently often and by sufficient magnitude to beat market averages.” – Charles Ellis, 1975


Photo Credit: MLBreports.com

Ted Williams is the last baseball player to hit over .400 and that mark hasn’t been challenged since he did it in 1941. Because of quality of play in Major League Baseball, it may never happen again.

The batting average for the entire league these days is actually pretty similar to range that was in place back in the 1940s (.260-.270). So why will it be so difficult for a player to hit .400 today?

Because all of the players are much better than they were back then.

It’s that the variation around the average was much wider back then. There were higher highs and lower lows.

The talent level was more spread out. With increased competition from more foreign-born players, better nutrition (insert steroid joke here), trainers and more knowledge about the game, both pitchers and hitters have gotten much better.

Since everyone is better, everyone will perform closer to the league-wide batting average. So, it’s not that the hitters today aren’t of the same quality as Ted Williams, it’s just that all of the pitchers and hitters are much better today than they were back then.

Therefore you can assume that it would be harder for Williams to hit .400 today (not impossible, but harder).

Let’s see how Ted Williams can help you view your investment options.

INDEX FUNDS
Many advocates of index fund investing mistakenly assume that all active fund managers must be getting worse over the years. They see that the historical results continue to show the outperformance of index funds over active funds and that the numbers only get worse for active managers over longer time frames.

So that means that investors must be getting worse over time, right?

What’s actually happening is that investors are getting much better. Michael Mauboussin termed this the paradox of skill in his book, The Success Equation (which is also where I got the Ted Williams information). So as skill improves, performance becomes more consistent, and therefore luck becomes more important in determining the winners and losers.

It’s not that investors lack skill. If anything, investors have become more sophisticated. But individual investors are now competing against hedge funds, private equity, large mutual fund companies, computer algorithms and day traders, not to mention index funds and the market in general.

The paradox of skill leads to narrower performance for all, much like the batting averages for MLB players.

Here’s Mauboussin in a recent interview:

It’s not that managers have gotten dumber. It’s precisely the opposite. The average manager is more skillful than in past years. The paradox of skill says that when the outcome of an activity combines skill and luck, as skill improves, luck becomes more important in shaping results.

COSTS MATTER MORE THAN EVER
With a narrower range of investment returns, costs become much more important than ever in determining your results. But as skill has improved, costs for active funds have basically stayed the same. This makes it harder for them to prove their worth.

Higher costs coupled with a lower number of investors outperforming by a wide margin leads to an even higher probability of index fund outperformance.

John Bogle’s Cost Matters Hypothesis (CMH) goes like this: overall, investors will earn the gross return of the total stock market before costs, but share only market’s return that’s left over after costs are deducted.

It’s also very difficult for individual investors to assess the skill of active managers. Most of the time investors simply look at past performance, which we know says nothing about future performance. Here’s Mauboussin again:

“If an investor believes that he or she can assess skill, they should use active managers. If they have no time to think about managers, then indexing makes sense.”

You can’t control the markets or how other investors will react to certain events. You can control the costs that you pay to be in the market, which will determine how much of the market return you earn net of those costs.

As skill continues to increase, you can increase your probability of earning market returns using simple index funds or ETFs.

The case for indexing has always been strong. Increased skill in the industry will only make that case stronger in the future.

Sources:
The Success Equation
Spotting the Next Superstar Manager (Kiplinger)

And here’s what I’ve been reading this week:

  • Great stuff on mean reversion from Barry Ritholtz (Big Picture)
  • Nine surprising things Jesse Livermore said (Reformed Broker)
  • What should I do about [recent economic event] (Oblivious Investor)
  • Physics can send a satellite to Jupiter, Economics cannot tell you what happened yesterday (Big Picture)
  • The true role of an investment adviser (Rick Ferri)
  • Who should try to beat the market? (Motley Fool)
  • George Clooney with a nice takedown of a hedge fund (Deadline Hollywood)
  • The teacher who makes $4 million a year in S. Korea (WSJ)
  • Another great Michael Lewis piece on Goldman Sachs (Vanity Fair)
  • Pay down debt or increase your investments?  (My Own Advisor)
  • Stocks: getting ready for a train wreck (WSJ)
  • Why Americans are turning against beer (Atlantic)
  • The joy of using a $2 bill (Altucher Confidential)
  • Zombies on Wall Street (MarketWatch)

  • Subscribe to the Common Sense monthly newsletter:

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