No one would enter a restaurant, let alone board a plane, if they were told that the average chef or pilot were less competent at their job than a blind-folded monkey. So why is there almost $100trn in the active funds industry when research has shown that a visually-impaired primate has a good a chance of beating the benchmark than the average active fund manager?
Let’s cut straight to the chase by acknowledging the following:
- Alpha across the world is a zero-sum game so the “average” investor’s performance must be zero, less costs. Even if the average active fund manager has more skill than the average investor, it is not sufficient to offset the costs of active management.
- Behind these “average” numbers lies a wide dispersion of active manager returns, driven by randomness and luck. However, a small, but material sub set of managers have demonstrated a level of persistence of outperformance that statistically can’t be due to luck alone. It implies skill.
Randomness and luck
If we can agree on these points, the discussion can then move onto the crux of this debate: how do we identify these skilful managers in advance?
We know this is the crucial question because past performance is rarely a guide to the future. For the vast majority of fund managers good past performance is more likely to be due to randomness and luck than anything else, which is not repeatable.
Skilled managers, whose positive track record has been driven by skill, could be a guide to the future but only if supported by a judgment that the conditions in place that drove that historic outperformance will be there in the future. So we can’t rely on past performance to identify skilled managers in advance.
The academic evidence is quite favourable towards active share – a measure of a manager’s ability to deviate from the benchmark – as a predictor of manager outperformance. This is intuitive: skilful managers need to deviate from the benchmark to have at least the opportunity to outperform. But it also gives unskilled managers the opportunity to underperform.
The result is that high active share is a reasonable requirement for active fund management outperformance, but without the tools to assess other requirements for outperformance, investors run the risk of picking a fund with a manager who has been a given a lot of leeway to underperform.
A second, reasonably strong predictive factor is assets under management. Although it will vary by strategy, generally speaking, higher assets under management leads to worse relative performance. Other studies have shown that high concentration and low turnover also have generally positive effects on active management outperformance, although what constitutes appropriate concentration or turnover also varies by strategy.
A culture of investment excellence
The key to determining future outperformance is the human characteristics of the investment decision-makers: their knowledge, incentivisation and whether the organisation they work at instils a culture of investment excellence. Unsurprisingly many academics have also tried to establish a statistical link with outperformance. Equally unsurprisingly, no strong correlations have been identified.
This reflects our own experience as fund selectors. The focus on trying to identify that small portion of skilful managers in advance of their outperformance has led us to focus our efforts on funds that exhibit certain characteristics – but this barely gets us a third of the way.
Beyond that, fund selectors need to use their skill and experience to identify investment philosophies that resonate; that are implemented by a repeatable and robust process; and executed by individuals with the appropriate skills, experience and temperament.
That this sounds “woolly” and unscientific is not a reason, in our opinion, not to persist. But it is a reason to take active fund selection seriously. The evidence is clear that there is the skill out there to outperformance persistently net of fees. It is difficult, but not impossible, to find it.
Andrew Summers is head of collectives at Investec Wealth & Investment