Some say it is better to be lucky than good, but when picking a fund manager, how much can be accredited to skill versus pure good fortune? And how can investors know the difference?
One of the first things many investors look for when assessing a fund manager’s skill is past performance. After all, performance is ultimately what investors are looking for when they decide to invest with a manager.
However, not all market returns can be attributed to skill. There are some fund managers who will admit that some of their outperformance can be indeed attributed to luck.
For example, the few value managers who had the good fortune of buying GameStop before the Reddit-induced short squeeze at the start of the year would be the first to admit that although they also saw value in the supposedly dying retailer, they did not anticipate the more than 15-fold increase in the company’s share price.
This is why Vanguard, known widely for its low-cost passive index funds, spends a lot of resources trying to determine whether a fund’s performance has been due to luck or skill when picking managers for their active business.
Andrew Surrey, national senior development manager at Vanguard said there are more than a dozen different measures that can be looked at.
“It's not like driving a car where you just need to be keeping an eye on the speedometer,” he said. “That would just be one lens to look through, such as past performance. If you could lean on one thing, it'd be easy and we wouldn’t employ several dozen very experienced investors to generate recommendations
“It’s more like in a flying a plane where actually you need to know lots of metrics. Just looking at your speed when you're flying a plane would be dangerous for obvious reasons.”
Below he reveals three specific measures that Vanguard’s oversight and manager search team use to try and tease apart what is luck, and what is skill.
Sizing skill
One metric that can be assessed is sizing skill – the simple act of looking to see if a fund manager had more outperforming companies in their fund than not. Then Vanguard adds the next layer: looking at position sizing.
“If the company that they invested part the fund in was only 0.5% and it went up 10 times, and that's where the performance came from, was that skill or was it luck? You would probably lean more towards luck,” he said.
Conversely, if a manager made the company a more significant part of the portfolio and had proven to be able to consistently do this over time, “then actually there’s some skill there in identifying which companies are going to beat the market”, he added.
Stripping out factors
Another way to assess a fund manager’s performance is to take out all the factors that may have contributed to a portfolio’s returns.
A factor is any characteristic that can explain the risk and return performance of an asset, such as value, growth or momentum.
For example, determining how much of a fund manager’s performance over the past decade was down to being a growth manager when interest rates were cut to zero and growth as an investing style outperformed versus how much of it was down to picking the right growing companies.
Surrey said: “So how much was due to the fact that they were a mid-cap manager that has always been overweight healthcare – that's just who they are – and mid-cap healthcare just happened to have been the thing that performed over that period.
“Taking all of that back out of it in a mathematical way and asking whether once you've taken all those factors out of it, is there still residual skill over time?”
He said this process can often take a long time and a lot of data to get a definitive answer where Vanguard can confidently attribute performance to skill, and not luck.
A team approach vs a star manager
The third key metric that Vanguard has found to be a good predictor of manager skill over the past fifty years is when a fund has a team approach, rather than a star fund manager, Surrey revealed.
He said it is important to have a genuine team in a firm where people are given the opportunity to question investment ideas, no matter how revered the manager is.
Surrey praised how the managers of Baillie Gifford’s Alpha Growth fund, which manages half of Vanguard’s Global Equity portfolio, all have very different backgrounds and ways of thinking.
“For example, in the Baillie Gifford Global Alpha fund – that's three investors who have all got to be on board and they all think very differently,” he said. “So getting three investors within Baillie Gifford to all say ‘yes I think this is going to work’ is their bar.
“We like that team approach which has been proven to work better than the opposite time and time again.”