SumGames - Is It Luck or Skill?


Active Management



How Much?


Odds of Success












     It is a critical question that is asked far too infrequently in the investment business and few attempt to answer it. Unfortunately, it's also not a question that is easily answered in most cases. Statistical analysis of the probability of success resulting from skill are subject to numerous assumptions, some of which tend to vary over time. Additionally, the average tenure of equity portfolio managers is typically six years or less, which is usually less than the time required to determine whether skill or luck is responsible for outperformance or underperformance.

     The research cited below strongly implies that it is very difficult to identify skilled managers. I believe there are skilled managers out there, but I have some unique experiences that allow me to make that statement and it's very complicated to attempt to identify them and invest with them in advance. Not only have I worked directly with some talented managers that I believe have skill, I've had the opportunity to analyze their trades (for them) over extended periods, so I've personally seen cases that lead me to believe there are clear examples of skill in stock picking. However, I believe they are a small minority of the number of managers that think they have skill (many of which have substantial assets under management).

     There are many "buts" in trying to profit from skilled managers. First, it's very difficult to identify them in advance, especially without proprietary information. Second, once they become successful they tend to attract significant assets, thus making it harder to take advantage of their skill (in fact plenty of successful managers close their funds to additional investment). Third, it's not unusual for teams to split up, or for staff members with knowledge of the skill to break off, which can ultimately lead to more money chasing the same anomalies. Fourth, unsuccessful active management efforts tend to get terminated, while successful efforts tend to survive, creating a survivorship bias issue that often complicates the analysis.

     Despite all the complications, in recent years there have been some very serious and professional studies addressing the question of whether skill can be differentiated from luck in the investment business. The bottom line is that it is very complicated and difficult to identify skilled managers and generate profits from investing with them. Below is a collection of studies and research on the topic.

Links and References

Let’s start with the Investment Industry component. It is so obvious in this business that it’s a zero sum game. We collectively add nothing but costs. We produce no widgets; we merely shuffle the existing value of all stocks and all bonds in a cosmic poker game. At the end of each year, the investment community is behind the markets in total by about 1% costs and individuals by 2%. And the costs have steadily grown. As our industry’s assets grew tenfold from 1989 to 2007, despite huge economics of scale, the fees per dollar also grew. There was no fee competition, contrary to theory. Why? Clients can’t easily distinguish talent from luck or risk taking.
Jeremy Grantham in GMO's 2000-2009 Review.





Gary Karz, CFA
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