We bestow fame and fortune on the elite group of money managers who have generated “outstanding” investment performance. They are featured in glossy business publications, their products command premium prices, and their words are taken as investment gospel. Indeed, one or two of them may be gifted and worthy of our praise. Perhaps they are even deserving of the riches we bestow on them when we pay them their fees. However, it is more than likely that we are taking advice from and enriching an elite group who are merely lucky.
Here’s how it works. Imagine 5,000 people (portfolio managers) calling heads or tails as someone flips a coin in a game (the markets) where the winners advance and the losers go home. After six coin flips, there will be 75 to 80 people who made all the right calls. If these people were stock or bond portfolio managers, Morningstar would bestow a 5-star rating on them. If they managed private equity or real estate funds, consultants would recommend them to endowments and pension plans. On the other hand, if these people had been playing the lottery, we would not be interested in investing money with them or taking their advice, even though most portfolio managers and all lottery winners share the same trait: extremely good fortune.
For those investors who consistently place their money with the six-time winners, the results are likely to be worse than the average. The supposedly brilliant manager who “saw” the credit crisis coming and sold mortgages will not see the next twist in the financial road, and his new investors will suffer as his returns revert to the mean or worse. Moreover, as investors clamor to give their money to the six-time winners, the “winning” managers have more money than they can possibly deploy in a productive manner, and the ensuing returns will be mediocre. The manager will, of course, be handsomely rewarded as his fees will have doubled or tripled before it’s clear that his luck has run its course.
More lucky than gifted
Admittedly, some of the achievers will continue to perform well. Remember that someone who has called a coin flip correctly six times has the same odds (50 percent) as he did on every previous toss. With a string of winning years memorialized in attractive marketing material, we commit ever greater amounts to chasing past performance.
Of course, there probably are one or two managers among the “winners” who are truly gifted, but it’s almost impossible to tell the difference between the lucky and the talented. Both types of “successful” managers will bombard you with sophisticated marketing pitches and pearls of wisdom, so it is next to impossible to separate the gifted from the lucky. I don’t think individual investors can make the distinction, and I know that institutional investors are not any better.
I believe it is human nature to be attracted to these seeming winners, so this game will persist. We will forever throw our money at managers with winning track records and withdraw our funds from underperforming managers.
I’m quite amazed at how little data we require before being drawn into this game. In my example, I postulated that a money manager had performed well for six consecutive years. In the real world of investments, the unsound practice of throwing capital at money managers often occurs after the manager has had a couple of decent quarters. Supposedly sophisticated investors have been known to beg hedge fund managers to take their money based on three or four months of attractive results.
There’s an even more troubling aspect of this phenomenon. Not only do we give these managers our money, we also listen to this lucky elite on matters far removed from money management. While they certainly know something about investments, they don’t know more than the rest of us about social problems or government policy, and yet we seek their insight on these subjects. We would be better served if we confined our adoration to things worthy of high praise.
Andrew Silton is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/