Back in my schoolboy days, there were kids we referred to as “book smart.” We applied the term to kids who were highly successful in the classroom, but not nearly as successful in the real world. They seemed to lack common sense and an understanding of practical things.
There were other kids we referred to as “street smart.” They were intelligent too, but did not necessarily shine in the classroom. Instead, they seemed to have great insight into how things worked in practice and were experts at navigating the real world. They were worldly wise.
Recently, it occurred to me that these descriptions have applicability in the investment world. At our firm, we believe active management can add value to client portfolios, that skill exists and that some active managers are simply more talented than others. We have worked for years on refining the process of identifying those managers and combining them in portfolios so their unique investment processes complement one another.
Periodically, I read studies proclaiming skill does not exist among active managers. The authors of these studies—mostly academics—have impeccable credentials. Their math skills are, well, a whole lot better than mine. Yet I know their conclusions are wrong. I see evidence of that every day. These academic studies simply do not mesh with my real-world experience.
The more I try to reconcile these studies with my experience, the more I come to the conclusion that the authors of these studies are book smart, but not very street smart. There are several reasons I’ve reached that conclusion.
Markets Are Not Totally Efficient
The main reason academics think active managers cannot add value is that markets are “efficient.” By that, they mean information travels so quickly and becomes generally known so rapidly that securities’ prices almost instantaneously reflect their true value. And this makes it virtually impossible to find “underpriced” or “mispriced” securities. And if securities are always accurately priced, active managers can add little value.
This theory reminds me of Zeno’s paradox. Zeno was a Greek philosopher who argued that you could never actually get anywhere because in order to get there you first had to get halfway there. Since you can always divide the distance between two places into smaller and smaller distances, you can get closer and closer to your destination, but you can never actually get there. It’s a great theory, but it does not accurately describe the world in which we live.
Certainly the securities markets are pretty darn efficient. But completely efficient? So efficient that a skilled active manager couldn’t find hidden opportunity from time to time? This idea flies in the face of our everyday, real-world experience.
We have all experienced bubbles and have seen run-ups in the value of individual stocks that cannot be explained from an efficient market perspective. The tech bubble comes quickly to mind as an example. Tech stocks rose in value dramatically during the late 1990s in a manner that cannot be explained by traditional measures of value. People simply fell in love with hi-tech. This phenomenon was described in Robert Shiller’s book Irrational Exuberance. Fund managers who were not smitten, like those at First Eagle Global, fared very nicely.
We saw another example of this recently. A handful of smart, diligent managers like Jeremy Grantham used publicly available information to predict the imminent bursting of the housing bubble. The information they used was there for all to see, but you had to know where to find it and how to interpret it. Granted, the number of managers who saw the tsunami coming was incredibly small and the number who sensed its potential magnitude was even smaller. Nevertheless, their accomplishment shows that broad access to information does not totally level the playing field. Intelligence and hard work still count for something.
In fact, this may be even truer as the volume of available information continues to increase. I can’t “unsubscribe” from new information sources fast enough as I vainly try to keep my inbox manageable. The ability to sift through information may be even more valuable today than the ability to gain access to it. Computers can help keep us from drowning as we try to drink from the fire hydrant of data on the Internet, but they still lack wisdom and judgment.
The efficient market hypothesis has another flaw—it assumes that all investors are similarly situated and that their motivations are the same. It does not take into account factors such as taxes, currencies and leverage that might affect whether a security is “properly priced” from a particular investor’s point of view. For example, a security that is properly priced from the perspective of taxable investors may seem like a bargain to non-taxable investors who will not have to pay taxes on their gains when they sell the security. Not all investors are the same.
Even the proponents of the efficient market hypothesis offer up different flavors of the theory—there is a “weak” version, a “semi-strong” version and a “strong” version. Each variation purports to explain the extent to which markets are truly efficient. This debate within the academic community reminds us that the efficient market hypothesis is, well, just a theory. And there is a growing group of academics who do not subscribe to any version of it.
Academics in behavioral finance, for instance, have produced reams of studies taking issue with the efficient market hypothesis. The behaviorists study the way human emotions such as fear and greed drive bubbles, manias and other irrational investment behavior. When markets are driven by emotion, skilled managers can find opportunity.
As you can see, there are more than a few cracks in the efficient market hypothesis. This raises the question: Are these cracks big enough for a few handfuls of skilled managers to slip through in their quest to find value in the securities markets? Even the most vehement efficient market proponents acknowledge the evidence that some active managers add value. But they assert that this extra value is the result of luck, not skill, and is therefore not sustainable. (See Luck Versus Skill In The Cross-section of Mutual Fund Returns, a paper by Eugene Fama and Kenneth French, 2010.)
Monkeys and Typewriters
They say if you put enough monkeys in a room with enough typewriters and let them bang away, eventually one of the monkeys will type a flawless version of Hamlet. That is how efficient market proponents explain the added value that some active managers clearly add. They are just lucky, not skillful.
The math they use to reach this conclusion is pretty impressive. Even the book smart kids I knew back in my school days would have stood in slack-jawed awe. But like Zeno’s paradox, it just doesn’t add up. You can calculate the odds of particular outcomes and analyze normal distribution curves all you want, but how do you conclude that a manager is just a typewriter-pounding monkey if you never talk to the manager, study the manager’s process or analyze the manner in which that process is implemented?
If you looked at them side by side, the transcript of Hamlet typed by the monkey would look exactly like the version typed by Shakespeare himself (assuming he had a typewriter). But if you sit the monkey and the Bard down and ask them a few questions, the differences become apparent pretty quickly. The academics never do this. Instead, they use higher mathematics to prove that the results of active management could be the result of random chance and then make the logical leap that they were the result of chance. My street smart friends would have greeted these mental gymnastics with a Bronx cheer.
Who Cares About the Average Manager?
In 1991, another smart academic, Nobel laureate William Sharpe, wrote an article called The Arithmetic of Active Management. In it, he asserted that since investing is a zero-sum game, the average active manager could not add value after accounting for fees. For that reason, he suggested passive investing was the way to go.
I find that conclusion interesting, but not very relevant to the quest for skilled active managers. It is like saying no team can actually win a baseball game because there is always a winner and a loser and if you average them together, you get … well, you see what I mean.
Proponents of passive investing also justify their views by pointing out that, over some time period of their choosing, a significant percentage of managers did not “beat the market” or some other benchmark. Again, the fact that some group of managers did not beat a particular benchmark over an arbitrary time period does not mean that no active manager adds value.
No matter what profession you look at, you will always find that its members range from brilliant to boneheaded and most will fall somewhere in between. I practiced law in Washington, D.C., for a while and I met very few truly exceptional lawyers. Yet the town was crawling with attorneys and most made enough money to put food on the table and buy a nice house. Looking at their performance as a group would not help you find the good ones.
Skill Exists, But It Is Hard To Measure
People have theorized about the existence of subatomic particles since ancient times. But it was not until 1897, when J. J. Thomson discovered the electron, that the existence of these particles was confirmed through scientific observation. Those who sought evidence of subatomic particles before Thomson’s discovery did not fail for lack of intelligence or diligence. They were simply using the wrong tools.
Why are the book smart academics searching for evidence of manager skill having such a hard time finding it? They are very intelligent and their math skills are fantastic. Why can’t they find something that we see in our work every day? They are using the wrong tools.
Good managers seek opportunity wherever they find it. Yet the studies often try to identify a manager’s skill by comparing his or her performance to a single index. This might work if managers restricted their search for opportunity to a single asset class. In the real world, few of them do. Why would they? Opportunity does not limit itself to a single asset class. In fact, some research suggests that the farther managers go from their single-index benchmark, the more likely they are to outperform that index. (See the paper How Active Is Your Fund Manager? A New Measure That Predicts Performance, by Martijn Cremers and Antti Petajisto, 2007).
Good managers also tend to have their own unique approaches to investing, much like good painters have their own unique styles. A van Gogh looks nothing like a Rembrandt. Yet academics often use peer group comparisons in an effort to identify manager skill. This might work if all the managers in the peer group invested in essentially the same way, but they don’t.
Success in almost any field requires an element of creativity, and active management is no exception. I live in Denver, so I have the privilege of watching future Hall of Famer Peyton Manning, quarterback for the Denver Broncos. He is still a great athlete, but he is getting older and has been hampered by some serious injuries. Yet he is having one of his best years ever. He stands on the same field as the other players and sees the same things they see, but he is better at interpreting what he sees and is more creative in his response to it.
Skilled managers do the same thing. As the efficient market theorists will tell you, we all have access to essentially the same information. However, truly skilled managers are better at gleaning which information is important. They are also better at drawing meaning out of that information and developing a creative approach to capitalizing on it.
Access to information is only the beginning of the creative process for investment managers. The efficient market theorists would have us believe that it is the end all and be all of investing and that it determines the outcome of the game. This is not true in any other human endeavor. Why would it be true of investing?
Skill exists among active managers, but as in most areas of endeavor, it is relatively rare. Not every movie wins an Oscar. Not every horse wins the Kentucky Derby. It is easy to identify the winners after the prizes have been handed out, but it is very difficult to identify the future winners. Yet as investors looking for skilled active managers, that is our job.
Scott A. MacKillop is president of Frontier Asset Management, a firm that constructs and manages portfolios for financial advisors and their clients. He is a 36-year veteran of the financial services industry.