James Saft

The better investors get, the less it avails them

August 13, 2014

Aug 13 (Reuters) – The good news is that active investment
managers are almost certainly better than ever.

The bad news is that it matters less and less.

Called “The Paradox of Skill” by Michael Mauboussin, head of
global financial strategies at Credit Suisse, this is the idea
that as the range of skills among players in a given game
narrows, the relative importance in luck in determining outcomes
rises. (here)

In other words, as the poorer players get squeezed out, as
they tend to over time, those with higher skills find fewer
mistakes to exploit.

With outperformance from relative skill harder to come by,
results driven by luck, which remains constant, become
relatively more important.

Stephen Jay Gould, the late Harvard paleontologist and
polymath, used this framework to explain why Ted Williams was
the last batter in Major League Baseball to hit .400 over a
season. He showed that the coefficient of variation in baseball
statistical performance has declined steadily over the decades,
something consistent with a better average standard of player
and a steady supply of luck. In short: fewer bad pitchers to
fatten one’s batting average.

As a (very) modestly skilled poker player, I saw this in
action when poker first became popular online in Britain, where
I was then living, about a decade ago. When the craze first took
off, the pickings online were rich, especially on sites that
attracted many players from Britain and Europe, many of whom
were more recreational gamblers than experienced poker players.
Over time, selection took place, with many bad players dropping
out, or becoming better. Eventually it became harder to win, and
lucky and unlucky runs of cards seemed, at least, to play a
larger role.

As it was with poker online, so it has been in the
investment world.

Mauboussin, building on work by Peter Bernstein from the
1990s, shows that statistical measures of outperformance by
large capitalization mutual funds in the United States have been
declining steadily for almost five decades, with the standard
deviation of excess return now less than half what it was in the
late 1960s.


That is consistent with an overall rise in skill among
investors, not least because more investing is done by
professionals. It would also be true, to the extent that you
believe that skill is identifiable by those with capital, that
the growth of hedge funds only reinforces the negative impact of
this on investors. If investment outperformance is a zero sum
game, and if hedge funds are better at this game, they will
capture more of that investment alpha. As hedge fund managers
capture more of the upside for themselves, by way of fees, the
implication may be that the race toward skill has only made
outperformance harder to come by in aggregate.

Mauboussin argues that under the circumstances, the key is
to pick the right game in which to play. He offers a
non-exhaustive list of three candidates: diversity breakdowns,
institutions versus individuals, and trading with investors who
are buying for reasons not to do with the fundamentals.

What he calls a diversity breakdown is when an unusually
high number of market players is lined up on one side of a
trade. These so-called crowded trades, for example the one
personified in 2007 by the idea that U.S. real estate prices
could not fall sharply in every region simultaneously, can break
down very rapidly and with huge jumps – or falls – in price.
They can also go on so long that your clients abandon you and
you lose faith in your own judgment, but that is why they can be
so profitable.

Institutions vs. individuals is exactly as it sounds,
essentially the search for markets, such as frontier emerging
markets in which less-sophisticated and skilled investors play a
relatively greater role.

The search for non-fundamental sellers is best personified
by the popularity of estate sales, in which the heirs are
seeking to liquidate not because that hedge trimmer has fallen
in fundamental usefulness but because it now belongs to someone
who will get less utility out of it.

In the corporate world, spin-offs are a good example. Since
a proportion of the new owners of the spun-off company won’t
want to bother doing the research on the spin-off, or won’t like
its risk profile, the post-spin off price often represents a
bargain to longer-term value.

For those of you either unsure of your place on the food
chain or simply aware of how few investors beat the index when
taking costs into account, the simple answer may be just to
abandon active management altogether.

(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by Dan Grebler)

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