Saying you're a skilled investor versus proving you are
Asset owners invest in active funds on the belief that the manager or team possesses a minimum level of investment skill or proficiency. However, is this defined, explicitly illustrated and then developed?
The truth is that it’s broadly not defined, it’s illustrated incorrectly and it’s generally not developed.
Below are common myths that don’t define or illustrate skill in investing:
- shorter term returns of a fund
- the intelligence of the PM
- the number of years of investment experience of a team
- historic examples of being right on individual positions
For decades, skill in active investing has been ‘proven’ via a confident, scripted story that is often only loosely based on reality. Equally it has relied on more short-term performance history (when it exists), and ‘successful’ trades, to validate this skill.
Being smart as an investor is also not directly linked to being a skilled investor. As the famous quote by Richard Feynman reads:
‘Smart doesn’t make you right: it just makes you in many instances, better at thinking you are’
Just as the world has changed dramatically post pandemic, it seems that we are also now seeing the emergence of more demanding asset owners who aren’t satisfied with a sales pitch but need explicit, tangible evidence that skill exists and is being developed.
It sounds obvious, but skilled investing is not lucky investing. You can develop skill but not luck.
I suggested to an asset owner last week that they ask the data focused CIO of an asset manager they invest with, what evidence they collect on the existence of luck in their benchmark plus returns
Every performance activity has a combination of skill and luck. Some activities are more skill driven - tennis, swimming and chess are examples. If you execute your good technique as a swimmer, you’ll swim well. Good process directly results in good outcome.
Clearly some activities are totally luck driven, roulette and good process doesn’t matter.
Finally, some activities are influenced in a more balanced way between skill and luck - for example, poker and contrary to many peoples belief, investing.
Buying a stock that goes up isn’t necessarily skill. Something you own going up for the combination of reasons you didn’t suggest, is luck. Owning and following a good process in an activity where skill and luck are more equally distributed, will usually result in a good outcome, but only over long periods of time.
Skill is control, luck is the randomness. Develop what you control. Buffett and Munger stick religiously to the stuff that’s in their ‘circle of competence’ and constantly refine. They do however fully understand that cause and effect are much less linked than most believe and that getting comfortable with ‘probably’ is at the heart of their success. This is hard to accept if you think investing is a game where skill is good outcome, bad luck is bad outcome.
At the core of skill or proficiency in investing is control of the process, not control of the outcome. Rules and feedback are vital for any good process. With a high skill game like chess, post-game feedback on the movement of the rooks is clear and useful for your rules because there is a close relationship between cause and effect. However, in a game involving much higher randomness (like investing), near term outcomes are inconclusive as there is much more uncertainty between cause and effect. That doesn’t mean feedback is less relevant, it just means feedback needs to be captured differently.
Active portfolio managers often find it difficult to convey their genuine value add or circle of competence. All too often it is very generic or vague (growth at a reasonable price as an example). This is widespread and problematic. Much more specificity is needed on their rules or guidelines in any process. Broad, vague and stale is the norm. Given that active managers are looking to market a skill at a high price, it would be useful to know what it is!
Having an explicit way to better untangle skill from luck in an investment feedback process is vital, but I think it it requires an investor to have a support team, data on the character of the PM(s), their simplified decision rules, and patience with execution of feedback loops over long periods of time.
I find a great opening question when I first meet a new fund team, is to ask, “what currently are you specifically trying to improve about your process and show me the feedback loops you are and have been using to help?”
The answers are rarely clear.
Just as any game can be broken down into core constituents, so can investing. The component parts are many and varied, but useful examples are asset selection skill, selling skill, risk management skill and portfolio construction skill. All need a specific feedback mechanism that is consistently applied over time.
As an example, most teams are good at generating ideas from their own work or the work of analysts, BUT the transition from good ideas to great portfolios is rare. Most teams tend to create portfolios bottom up, but the best funds combine individual position human input with real mathematical process in a feedback loop that helps express the risk you want in a portfolio versus the risk you don’t want and in an explainable way. The latter portfolio tools incorporate investor needs of the portfolio, organisational needs of the portfolio and how different assets will likely move relative to each other in the portfolio.
My view is that given the amount of luck involved, the vast majority of PMs actually (subconsciously) end up reaching a plateau of skill that they feel is broadly ‘good enough’. Until now good enough has been good enough.
What distinguishes elite investors from the rest is that they can define skill. It manifests as clear investing rules which fit who they are, what they believe as individuals, and then they possess the hunger to advance beyond these natural plateaus through deliberate continuous refinement.
Proof of skill for active managers is the only way to compete with passive investing in 2021 and beyond.