“Skill is the ability to persistently outperform an appropriate benchmark.”
That is the finding of the NZ$26.8 billion (US$20.8 billion) New Zealand Superannuation fund, which has published a white paper—“Investment Manager Skill,” co-authored by Paul Gregory and Tim Mitchell—detailing their discussions on the subject of manager skill.
But there is more to selecting the best managers than simply identifying them, the duo wrote.
“Even where we identify skill in a manager and believe we have a good handle on its source, we must be able to access it in a way that maximizes the alignment between the manager and ourselves.”—Paul Gregory and Tim Mitchell, NZ Super
While benchmarks can be constructed to strip out the effects of market beta and risk factors such as value or growth premiums, Gregory and Mitchell said “the best ‘centrifuge’ for separating skill from luck is time.”
“This is based on luck being, by definition, random, and skill being deliberate action and therefore, theoretically, repeatable,” they wrote.
The pair also emphasized the importance of the market in which a manager operates.
“A market can be conducive to manager skill because it takes effort to acquire information about how it works and the behavior of its participants,” the authors wrote, citing their home equity market of New Zealand as a good example. “Alternatively, it may be conducive to manager skill because, to use a fishing allegory, we are more likely to find a successful fisher if we first find a productive pond.”
Once a manager is identified, the NZ Super team then assesses a number of elements to ensure the pension’s strategy fits with that of the manager so that the full potential benefits can be accessed.
“Even where we identify skill in a manager and believe we have a good handle on its source, we must be able to access it in a way that maximizes the alignment between the manager and ourselves,” Gregory and Mitchell wrote.
This can include ensuring fees do not erode the excess returns generated by the manager’s skill, as well as setting up legal agreements to ensure the optimum alignment between NZ Super and the new fund.
And it doesn’t end with a mandate being agreed. The authors stated that the team’s manager selection skills were “at least as important as the investment manager’s skill in generating extra returns.”
“The best way for us to assess our own competency in this regard is ongoing monitoring of the performance of the managers we choose, relative to other managers we could have chosen and did not,” they concluded.
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