How to Tell Whether an Active Fund Manager Was Skilled or Lucky

On a recent episode of The Long View, Amy Arnott and I talked to Andy Clarke and Nelson Wicas, co-authors of The Architecture of Wealth: The Art and Science of Portfolio Construction. We talked about behavioral bias, inflation shocks, and their insights from working with Jack Bogle.

Today, I’d like to highlight an excerpt from our conversation that focuses on luck versus skill when it comes to active management.

Does the Manager Know What Worked?

Christine Benz: For investors who want to continue to look for active managers who might outperform, how would you say investors could evaluate an active manager’s track record to give themselves more confidence that outperformance wasn’t a fluke, that it could have some persistence into the future?

Nelson Wicas: In the book, what we’re really talking about is how to form risk-controlled portfolios, whether it’s an index strategy or an active strategy; risk-controlled portfolios are essential to lead to success. When it comes to actively managed funds, there’s this law of active management from Grinold and Kahn, where it basically boils down to the idea that you need to place lots of little bets.

When it comes to evaluating active managers, what’s done in the institutional space is essentially attribution analysis. They look at the track record, and they look at what they are holding and what paid off. And those payoffs, how do they sync up with known exposures to risk factors? What came from true stock selection where it wasn’t a risk factor driving the return? If your performance during a time is largely due to a risk factor exposure, it may well be that there was just luck; you were just in the right place at the right time, the risk factor paid off, but you rode the wave.

But if you have an investment process that clearly is synced up to be betting on a risk factor or betting within stocks within the risk factor, then it may be plausible that they have a repeatable investment process. What you’re really looking for is that people who are managers that are picking stocks that are paying off, that are not coming from just a risk factor, because then the manager is truly generating information in their analytical process that’s leading to placing bets that are starting to pay off.

Typically, when you’re looking at active managers, they do this kind of analysis. They then interview the manager, and they listen carefully to what their investment process is, and they sync it up to the analysis they’ve done. Again, people I’ve known who do this for a living, they essentially are looking to see: Does the manager know why his process paid off? Does the manager know what risk factors he was exposed to? Does the manager know what was luck and what was skill?

And then you can, depending upon how much information you get, you can then try to simulate the strategy quantitatively to see whether or not, over longer periods of time, that strategy’s going to pay off the way you think. Essentially, when it comes to manager selection in the active space, it has become a very quantitatively driven approach that, again, is heavily influenced by academic finance, and the idea is it came out of academic finance.

Low Costs Give You a Head Start

Andy Clarke: I would just add that as an individual investor who might not have access to all these analytical tools, you want to start with a fund that’s low-cost, below-average-cost, that at least gives you a head start. And then try to understand the economic rationale behind a manager’s investment thesis. Why does this manager think a particular kind of stock will outperform? Are you able to see that rationale reflected in the portfolio holdings?

This is something that, as Nelson was talking about, you could do in a much more rigorous way with all these tools, but an individual can just see how the fund has performed during different market environments. If the fund is value-oriented, does it tend to do well in value-oriented markets, and does it tend to fall behind in growth-oriented markets? That’s not a problem. That just indicates that the fund’s doing what it says it’s going to do. I would start there as an individual.

Valentina Djeljosevic contributed to this article.