GMO White Paper: Is Skill Dead?
“90% of what passes for brilliance or incompetence in investing is the ebb and flow of investment style.”
As investment boards and committees gather to discuss performance for 2014, eyebrows will most certainly be raised as people review the performance of many of their equity managers. Depending on which database they are looking at, between 80% and 90% of active U.S. equity managers will have underperformed their benchmark this year, making it one of the worst years for active management in the recent past. Those particularly prone to hyperbole will use this as a clarion call to further embrace passive management and rid themselves of their active managers. After all, if only 1 in 10 active managers can actually generate alpha, why would investors bother with the time, headache, or cost of active managers? Not so fast …
It is incredibly important to avoid extrapolating short-term results. Just because active management in general has been through a difficult period, it does not necessarily follow that what is past is prologue. In today’s increasingly short-term-oriented investment culture, winning stock pickers are deemed to have exhibited superior foresight and brilliance while the losers have suddenly become idiots and are often shown the door. Reality is something quite different. In any given year, there can be a substantial amount of luck involved in outperforming a benchmark. Over a longer horizon, we think it is easier to make the determination between skill and luck. As investors find themselves asking questions about their active managers given their recent poor performance, we believe we have some insight as to what may be driving some of the headlines lamenting that performance.
U.S. Large Cap Manager Performance
The past year has proven to be a very challenging period for U.S. equity managers. At the end of the third quarter of 2014 only 17% of large cap managers’ returns had met or exceeded those of the S&P 500 over the prior 12 months (see Exhibit 1). It shows that the recent underperformance is not an unprecedented occurrence, but it is not terribly common either.
If investment managers were each following independent investment strategies, we would expect roughly half of these managers to outperform (gross of fees) in any given period. The data, however, suggests that it is far more typical for either two-thirds of managers to outperform, or fortwo-thirds of managers to underperform. Almost everyone wins, or almost everyone loses. This strongly suggests that there are some common factors that drive the performance of the typical manager and that these factors ultimately heavily influence their success or failure.
Because the data is broadly representative of the universe of institutional U.S. large cap equity managers, the explanatory factors are not likely to be found in the form of sector biases, value versus growth, or anything else that amounts to taking active positions within the benchmark. After all, for every active manager that is overweight a sector there is another who is underweight. Rather, the explanation must come from some systematic exposures that are taken by the majority of managers that amount to out-of- benchmark allocations. To keep things as simple as possible, we will focus here on investments in non- U.S. stocks, investments in small cap stocks, and cash holdings. Using the MSCI ACWI ex-U.S. index, Russell 2000 index, and 3-monthT-bills as proxies for each of these asset classes, we have plotted the
relative performance of these out-of-benchmark allocations versus the S&P 500 in Exhibits 2 through 4.