Active Managers: Skill or Luck?

Ever felt lucky? Perhaps you won a game of bingo at your church one Saturday evening. Maybe you won the drawing at the local Rotary meeting. Did you ever come back from a trip to Las Vegas with more in your wallet than you when you left?

Whenever you have felt lucky, did it occur to you that the outcome was totally beyond your control? Unless you were able to rig the results, you won because of the laws of chance. These laws suggest that results of such situations are distributed in a random manner.

Those on Wall Street would have us believe that certain money managers are able through the application of knowledge, skills and experience to achieve investment performance that is better than average. They point to notable figures like Peter Lynch who ran the Magellan Fund at Fidelity from 1977 to 1990 and who reportedly beat the Standard & Poor’s 500 index benchmark in 11 of those 13 years. Bill Miller, Portfolio Manager for the Legg Mason Value Trust mutual fund, beat the same benchmark for 15 consecutive years from 1991 through 2005.

I am not particularly persuaded by the suggestion that Peter Lynch or Bill Miller or any other money manager is somehow better than all the other mangers in the investment community. I am more inclined to believe that some managers were able to outperform the market, because the laws of chance tell us that in the universe of thousands of managers a few will.

Some will disagree and believe that some fund managers are more gifted than others. They are faced with another problem. How do you identify these managers before they put together their streaks of outperformance? I liken this to entering The Rose Garden in Portland. You walk to center court. Every seat in the facility (19,980 to be precise) is filled with a money manager. We can expect that the average performance of these managers will be that of the stock market, because this population is large enough to represent the market itself. However, we know that that some of the managers sitting in the stands will turn in performance that is better than the average. The question is who? If you are an investor you have to place your money with the managers you believe will beat the market before they actually do so.

I agree with Russell Wermers, Finance Professor at the University of Maryland who said, “[It is] exceedingly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade achieved that return almost entirely due to luck alone … By definition, therefore, such a fund could not have been identified in advance.”

Given that most fund managers do not beat the market, why would anyone gamble their financial future by investing with managers who they hope will beat the market in the future?