Michael Mauboussin: Excess Returns Require The Chance To Apply Skill

Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).

Visit his site at: michaelmauboussin.com/

Michael Mauboussin Excess Returns

“Ability is nothing without opportunity.” Napoleon

  • The fundamental law of active management separates the sources of excess return into two parts: skill and opportunity.
  • While the investment industry is in constant pursuit of skill, having lots of skill doesn’t pay off if opportunity is poor, and modest skill can yield attractive results if opportunity is rich.
  • We examine three ways that investors can express skill: market timing, security selection, and portfolio construction.
  • There is a strong correlation between years when active managers do well, measured as the percentage that beat their benchmark, and the relative performance of small versus large capitalization stocks. This reflects exposure to the factor “Small Minus Big.”
  • Measures of opportunity show that 2014 was a particularly challenging year. For example, the dispersion of stock returns was unusually narrow, creating a very inhospitable environment for active managers.
  • Pockets of inefficiency always exist in markets and investors should be explicit in seeking them.

Michael Mauboussin: Excess Returns Require The Chance To Apply Skill – Introduction

In the quest for market-beating returns, investors seek money managers who are skillful. But what if skill isn’t the only key to success?

More than 25 years ago, Richard Grinold, the former global director of research at Barclays Global Investors, developed what he called “the fundamental law of active management:”

Michael Mauboussin Excess Returns

In words, it says that the information ratio equals the information coefficient times the square root of breadth.3 If you are not a quant, don’t worry, there’s an even simpler way to convey the law:

Excess returns = skill * opportunity

The point of this report is that all of the skill in the world is for naught if you don’t have attractive opportunities. While the investment industry is focused on ways to ferret out skill, there is less discussion about where and how investors should apply their skill.

There are two basic conditions that present a challenge for skillful investors. The first is where the payoffs are potentially attractive but all of the competitors are very skillful. In this case, the skills of the players are offsetting and luck plays a large role in determining the outcome.4 For example, a good poker player who wants to make money should seek games with weaker players. Playing in highly competitive events may reveal prowess but is a tough way to make a living.

The second condition is when the payoffs are meager. You can be the most skillful person playing, but there’s not much to play for. Consider the draft in sports, the primary way that professional sports leagues assign amateur players to its teams. In some years the draft is rich with great players. But in other years there is a dearth of talented players. You can have the most skillful scouting and draft strategy around but your skill won’t pay off if the pool of players is poor.

In assessing the results of investment managers, it is useful to consider both skill and opportunity. In 2014, the opportunities were particularly limited, contributing to the relatively poor performance of active mutual fund and hedge fund managers.

Exhibit 1 shows the percentage of equity mutual funds that have beat the S&P 500 Index in each year since 1970. The average rate of outperformance during this 45-year period was 40 percent (less than 50 percent because of fees), and the standard deviation was 19 percent. Only one in seven of U.S. large capitalization equity managers beat their benchmark in 2014.

Michael Mauboussin Excess Returns

We now examine some measures of opportunity and briefly offer ideas about how to find attractive opportunities.

How Portfolio Managers Express Skill

There are three ways that a portfolio manager can express skill. The first is through market timing, the ability to buy low and sell high. The second is through security selection, a talent for identifying securities that generate returns that beat the market after adjusting for risk. The final way is through portfolio construction, the aptitude to make each holding the proper size so as to earn the highest excess returns possible for a given level of risk.

Market timing. There is little evidence that mutual fund and hedge fund managers can time the market. That said, it is hard to directly measure that ability. For mutual funds, a logical approach is to compare the level of cash as a percentage of assets to subsequent market returns.6 For hedge funds, we can examine the exposure to the market and future market moves.

The idea is when the market’s valuation is high and hence the expected return on equities is low, mutual funds should hold substantial cash. And when the market is cheap, funds should deploy that available cash to buy bargains.

Exhibit 2 compares the average level of cash for equity mutual funds from 1990-2013 to the total shareholder return (TSR) for the S&P 500 in the subsequent year. Were mutual funds good at timing, you would expect to see high returns following periods of low cash balances, and low returns following high cash balances. We see the opposite pattern. One academic researcher studying the issue concluded that “equity funds as a whole do not have market timing skills.”

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