This article first appeared in the 1st quarter 2019 edition of Personal Finance magazine.
American financial strategist Michael Mauboussin argues that all investing sits on the spectrum between pure skill (no luck) and pure luck (no skill). What is not factored in, however, is intention. “As an investment manager, if you can deliberately drive the outcome of the activity and repeat this, then more skill is involved,” says Vuyo Nogantshi, head of institutional client services at Allan Gray.
Is past performance the only means to assess skill?
Most experts agree that the responsible use of past performance is a good means of assessing manager skill. But Nogantshi cautions that basing conclusions solely on this past performance has its pitfalls.
He believes factors that are more accurate in determining an asset manager’s skill are appropriate benchmarks, the opportunity to outperform, how the investment is constrained and lastly, market factors.
Benchmarks enable investors to measure the performance of funds. “Investors should choose a benchmark which suits their own objectives,” says Nogantshi. He gives the example of using the mediocre English football team, Everton, as a benchmark against star performers Real Madrid, a completely inappropriate choice. “To assess how good Real Madrid is, we would need to position a similarly skilled opponent against them and assess how consistent their performance was over time.”
The opportunity to perform
Stocks in a market either move together or they diverge. “For opportunities for outperformance to exist for an active manager, the market should be diverging,” Nogantshi says. “This will help you assess whether the environment structurally allows your active manager to add value.” Bear in mind that different markets present different opportunities for outperformance. This is why it is important to assess performance over time.
It’s easy to look at two different funds and draw conclusions about which one is better. “But without clear knowledge of what constraints each portfolio faces (such as offshore allowance, asset allocation and mandate limits), some conclusions may be questionable,” he warns. “Make sure that your comparisons are fair.”
Stock markets can be distorted by the dominance of certain sectors. In South Africa, resources tended to dominate the market in the past, but today media giant Naspers accounts for a fifth of the top 40 shares on the JSE. “Situations such as these can distort investment outcomes,” Nogantshi says, “since managers could simply be winners or losers by holding or not holding a dominant share.” He adds that when assessing performance, investors need to ensure that performance was not the result of a single big bet.
What other factors point to a skilled manager?
To better judge skill over luck in investment managers, it’s important to consider the three Ps, says Nogantshi: philosophy, process and people.
“Philosophy is how an investment manager thinks about investments and how they invest over several market cycles,” he says.
Process is how the investment philosophy is implemented, while people, the third P, speaks about having the right people with the necessary experience.
“Understanding managers’ track records, processes, philosophies and people will give you a better sense of which managers are more dependent on skill and which are more dependent on luck,” he says.