Every football supporter knows the frustration of seeing their team miss a crucial penalty, as I did the other day. I’m sure I’m not the only fan to wonder on these occasions, just how hard is it to put the ball in the net from only 12 yards out? With a bit of coaching and regular practice, surely even I could do it, couldn’t I?
The fact is, yes, I probably could. Even I, with my total lack of sporting prowess, could beat a professional goalkeeper from the penalty spot if given the opportunity.
But does that make me genuinely skilful? Of course, it doesn’t. The point is, a Premier League penalty specialist could take, say, 100 penalties, miss the first, but still score 70 or 80 times or more. I, on the other hand, could somehow manage to score the first penalty and then fail to convert the next 99.
In other words, the fewer tests there are, the greater the chances are that a low-skill player can outperform a high-skill player simply down to luck. The more tests there are, the likelier it is that greater skill will prevail. To put it another way, genuine skill persists, but luck is ephemeral.
Is your fund manager genuinely skilful?
You might be wondering what all this has to do with investing. Well, the answer is that investors are often fooled by what they assume is skill, but it is actually nothing more than random chance.
As we’ve explained on the Timeline blog many times, very few active funds succeed in beating the market, on a properly cost- and risk-adjusted basis, over the long term. But we often hear of funds that have produced extraordinary returns over, say, one, two or three years.
The question is, to what extent is short-term outperformance down to manager skill? The manager, of course, is likely to say it is down to skill. Similarly, when a manager underperforms, they will often blame bad luck.
In truth, it’s actually very hard to say how big a part luck and skill have played in the performance of any one fund. But looking at the persistence of performance yields some valuable clues.
Outperformance rarely lasts for long
Researchers at S&P Dow Jones Indices regularly produce what they call Persistence Scorecards for active fund managers around the world. Recently, they’ve published scorecards for the US, Europe, Latin America, and Canada. What all of these scorecards show, yet again, is that outperformance comes in very short bursts. What’s more, a period of strong performance is often followed by a spell of poor performance.
Let’s take the US scorecard, for example. Only 5% of the above-median large-cap active equity funds in the calendar year 2020 remained above the sector median in each of the two succeeding years. If outperformance were purely random, we would expect a far higher repeat rate of 25%. Also, of all the large-cap funds that were in the top quartile for performance in 2020, not a single one remained in the top quartile for the next two years.
There is therefore very strong evidence of a lack of persistence even over a period as short as three years.
Poor performance DOES persist
Ah, you might say, but surely it works both ways? In other words, poor performance, you would think, would be similarly short-lasting. Unfortunately, when it comes to underperformance it works the other way around — there is persistence — and a poor performer is likely to remain a poor performer.
For example, 28% of all US equity funds in the fourth quartile, based on their 2012-2017 performance, were either merged or closed within the next five years. The comparable figure for top-quartile funds was only 10%. And, in case you were wondering, the results for active bond funds were about the same.
The logical conclusion to draw from statistics such as these is that when a fund manager outperforms over short periods, it might well be down to luck as opposed to skill.
Lessons for investors
So investors should be on their guard. Don’t be fooled by small numbers, and don’t be overly impressed by a fund manager who’s produced stellar returns over a year or two — even if everyone seems to be talking about them. There are so many funds to choose from that there will always be short-term winners, simply by the law of averages.
Stay focused instead on your long-term goals. Don’t chase performance, and don’t try to identify, in advance, the star performers of the future, because the odds are heavily stacked against you. In the long run, you’re likely to be better off by holding a passive (or at least broadly passive) portfolio and resisting the temptation to chop and change it.
Oh, and remember, don’t be too hard on your star striker for missing that open goal. He’s almost certainly better at football than you are.
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products
Robin Powell is a journalist, author and editor of The Evidence-Based Investor.
