At the 2020 Morningstar Conference, Michael Mauboussin spoke about the best of his most impactful and recent research. He questioned the value of active management and suggested a new way to measure manager skill.
Is Active Management Valuable
Michael’s presentations centered on his main tenet – active management does create alpha, but unfortunately, over the long run, this value add is negated by fees for the investor. He used a number of poker analogies, that while interesting, escaped this writer.
He began with a discussion of challenges that he felt were relative to both poker players and investors:
- For every winner, there has to be a loser (relative performance)
- Players in aggregate will end up with less money than they started if they pay to play (fees)
- The rise of indexing may lead to fewer weak players.
Michael’s stats revealed that as the market has evolved, it is harder to be a successful active manager and that active managers have been losing in the fund flow game for the last 15 years.
The Paradox of Skill
He agreed with a researcher Stephen Jay Gould, an evolutionary biologist at Harvard. His theory is called the paradox of skill. According to a paper by Credit Suisse discussing this concept:
“There are two aspects to success in investing: proficiency and choosing an attractive game. The key to an attractive game is dispersion in skill, where more skillful participants can benefit at the expense of less skillful ones. The paradox of skill says that in activities where results combine luck and skill, luck is often more important in shaping outcomes even as skill improves. In many competitive interactions it is the relative level of skill that matters, not the absolute level of skill. In many fields, including investing, the dispersion of skill is shrinking, which leaves more to luck. There is a positive correlation between the breadth of opportunities and the dispersion of fund returns. Pockets of inefficiency persist. These include diversity breakdowns, institutions competing with individuals, and trading with distressed counterparties.”
He mentioned that skill is absolute and relative. For instance, in the world, sports, business, runners all are doing better over time – runners are faster, batting averages better, but relative skill. The difference between the very best and the average guy has gotten less and less. His point is, it’s really hard to stand out; it takes a combination of skill AND luck that makes one manager better than the others. Over time, the bell curve has gotten quite skinny, meaning there are both fewer winners and fewer losers.
The Man Loves Poker
His advice to managers is based in poker: “Don’t worry about playing better poker player, instead think about where you can find weaker games, and thereby gain some advantage.”
He posits there is another way to assess managers, that is on the fund’s value-added gross profit. He says early on Peter Lynch had a very high alpha, but small AUM, so his value capture was relatively small. However, in his last five years, he had a small alpha, but a very very high AUM, rendering his value extraction much higher. I guess he’s saying he “made it up in volume.”
That said, he notes that in general, alpha drifts lower as the fund size gets bigger – nonetheless, the value extraction tends to be vastly larger as the fund grows.
Unfortunately, while mutual funds have added value over time, net positive gross profits in 2019, overall, roughly covered investor fees.
The Wisdom of Crowds
Michael also covered a concept known as the Wisdom of Crowds and how “wisdom” becomes “rage.” In his book, New Yorker business columnist James Surowiecki explores a deceptively simple idea: Large groups of people are smarter than an elite few, no matter how brilliant—better at solving problems, fostering innovation, coming to wise decisions, even predicting the future.
But, says Michael, three things must be present, heterogeneity, aggregation, rewards for being right and penalties for being wrong. In the investment world, when we lose heterogeneity, we increase correlation. So, when people jump on the bandwagon, we lose diversity. Then as a trend continues, there are no more buyers. This leads to a crash and diversity is restored. He sees a scenario then, where institutional investors are by far the winners over individuals.
In 2020, he says retail trading has spiked, which undoubtedly led to frothy activity that was not fundamentally based. He predicts it will likely not end well for new participant investors.