Luck vs. Skill in Active Management

In a post earlier this week I wrote about famed hedge fund manager Michael Steinhardt’s impressive track record from the late-1960s to the late-1970s. A few readers commented to me that nothing could be discerned from Steinhardt’s track record because it’s nearly impossible to separate luck from skill when making these types of historical performance comparisons.

The basic premise is that there are always going to be big winners, but no one knows for sure if it’s because they’re actually skilled investors or if it’s because they happen to be the luckiest dart-thrower that came out on top. While I agree that it’s difficult to quantify luck vs. skill and the markets are highly unpredictable, I would never go so far as to say that there are no skilled investors out there. That hasn’t been my experience.

The problem for asset allocators and individual investors is the fact that participating in that outperformance is always the hardest part. Timing matters when trying to beat the market, not because professional investors are ignorant or greedy, but because there are more highly skilled investors than ever before. With the amount of information available in today’s markets, it’s difficult to go unnoticed for very long if you put together a decent track record. This is both a blessing and a curse for portfolio managers.

Elizabeth MacBride of Stanford Business School shared some interesting research on this very topic this week:

In fact, research by Jonathan Berk of Stanford Graduate School of Business and Jules H. van Binsbergen, formerly of Stanford and now at Wharton, suggests that the typical mutual fund manager is persistently skilled, and that top performers are especially good. It’s just that the market is so hypercompetitive that most investors can’t benefit from the skill — it is competed away too quickly as money pours into emerging managers’ funds. The managers and their companies, rather than investors, capture the value of the total market earnings and fees charged to investors.

In the study cited by MacBride, researchers looked at nearly 6,000 mutual funds from 1969 to 2011 and compared their results to comparable Vanguard funds. They found the funds that made the most money in the past also continued to make money in the future relative to their benchmark. So the really great investors can definitely add value.

But here’s the catch (and there’s always a catch) — when investors discovered a great portfolio manager, they showered them with money. Since size is the enemy of outperformance, a larger asset base makes it much more difficult for the skilled managers to outperform at the same magnitude as they did in the past. They still earn more money than other managers, but it’s achieved through much lower returns because it’s spread out among a larger investor base.

By the time you subtract the fees paid, investors miss out on any of the remaining outperformance. Unless you’re a very early investor in the fund, you’re fighting for a much narrower slice of the outperformance pie with the increased competition for that manager’s abilities. So some mutual fund managers are skilled, but most investors probably can’t or won’t benefit from that skill. Competition is making it harder and harder to outperform at scale.

I also see this phenomenon as one of the reasons that index funds will never completely overtake active funds. The temptation will always be there to locate or chase the next best performing fund manager. The cycle will continue to repeat itself over and over again.

Here are a few questions investors should ask themselves when considering chasing the next best thing in active mutual funds:

  • Can the strategy scale in terms of assets under management?
  • Is there a legitimate reason for past outperformance to continue?
  • Do I understand the process of this fund or manager enough to see it through or add money during the inevitable dry spells?
  • How tax efficient is the fund’s trading activity?
  • Have I chased fund performance in the past? How well did it work out for me?

In terms of trying to decipher the role of luck and skill on an investor’s results, I’ve found that my experience with the best investors I’ve met with or read about is that they’re usually the first ones to admit that luck has played a role in their success. Humility is a requirement for longevity in the markets because nothing lasts forever.

Are Mutual Fund Managers Skilled, Or Just Lucky? (Stanford)

Further Reading:
World Class Comedy of Investing: Are They Teachable?
Benjamin Graham: Father of the Efficient Market Hypothesis?

Now here’s what I’ve been reading lately:

  • Better the devil you know and diversification (EightAteEight)
  • 10 word investment philosophies (Motley Fool)
  • 11 rules to live by (Big Picture)
  • A dozen business lessons from Ben Horowitz (25iq)
  • Should I really be buying stocks or bonds at these levels? (Oblivious Investor)
  • The problem with naive diversification (Mullooly)
  • The fear of getting started when investing (Abnormal Returns)
  • A visual history of market crash predictions (Fund Reference)
  • Inefficient markets are still hard to beat (WSJ)

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  1. larryqpc commented on Jul 17


    Well done! Thanks for the effort; it is appreciated. The blog is titled “A Wealth of COMMON SENSE” (my emphasis). So, your post comes down to the common sense result that ” market is so hypercompetitive that most investors can’t benefit from the skill — it is competed away too quickly as money pours into emerging managers’ funds.The managers and their companies, rather than investors, capture the value of the total market earnings and fees charged to investors.”.

    If most investors can’t benefit from the skill, then most investors WON’T benefit from the skill (as you yourself noted above). “Common Sense” then argues that if you can’t and won’t benefit from any outperformance, then outperformance should not (MUST NOT) be your goal. Otherwise, you are foolish (or an idiot: doing the same thing over and over and expecting different results).

    So the best investors, after their fees, are not going to beat the market. That has to raise the question as to why anyone should hire them with that knowledge aforehand? Seems to me if I know that the odds are impossibly against my manager beating the market, I should at least get the market return at low (almost no) cost. Pay 1% or 5/100 of 1%? Pay $10,000 on a million dollars or $500? What would the common sense answer have to be?

    I happen to think you are right that index funds won’t overtake active funds, and thankfully so. And it’s for the exact reason you note: the vast majority of people are investment idiots and their BEHAVIOR is the problem; they will work against their own best interests chasing the hottest 5 star fund and constantly lose out to the market. Thankfully, they exist, because we need people on the other side of the transaction since the market is, in the end, a zero sum game.

    I thoroughly enjoy your posts; I read many (MANY) financial postings/articles/journals, so that comment is not made lightly.

    Thanks for the effort.


    • Ben commented on Jul 17

      Thanks Larry. I agree that you should have a very good reason if your goal is to outperform the market. Simple math says it’s very difficult, especially when you factor in costs and taxes. As you say, behavior should be step one for every investor. Maybe I stole this from someone else, but I like the phrase it’s not about beating the market, it’s about not beating yourself.

  2. 10 Friday AM Reads | The Big Picture commented on Jul 17

    […] History of Market Crash Predictions (Fund Reference) • Luck vs. Skill in Active Management (WOCS) • The technical experts weigh in, and they’re pretty impressed with the Iran deal […]

  3. Clark Herring commented on Jul 17

    I agree well done. since the investment market has more skilled players will the truly skilled investors be able to achieve the alpha that skilled investors were able to achieve in the 50’s,60s and 70’s? I always remember that Market Alpha has to equal zero. Your observations seem to confirm my thoughts that trying to find skilled investor will requite an enormous amount of time and effort and some measure of luck as well. I think I will be lazy and stick to index funds.

    • Ben commented on Jul 17

      Yes, the time and effort required can be immense and you still may not achieve that goal. One of the few areas in life where being lazy has its perks.

  4. Market Map commented on Jul 17

    It’s a reasonable advantage to stay private, and manage and compound the money in a Roth IRA. No overhead or employees. And because it’s a Roth, a lid is kept on the taking of obscene, leveraged bets. One can then then charge fees for just “consulting”, and not for performance, if they wish …

  5. Is it luck or skill that makes a winner? — TechMASH commented on Nov 27

    […] that cannot be bought, it cannot be learned and it makes no difference who is behind you, if luck is not on your side then you are going to have to work much harder in order to achieve the goal […]