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Are You Lucky or Skilled?

From aiCIO magazine's February issue: Asset management’s most strident critics have long suggested that even the likes of Warren Buffett and George Soros are simply lucky. Are we moving closer to answering this fundamental question? Sage Um and Leanna Orr report.

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“Suppose you go into 32 bars. In 16 of them, you say the Celtics are going to win tonight, and in 16 you say the Celtics are going to lose. Return to the 16 you were correct at, and repeat the process for the next five games. Then, go into the bar where you’ve been right six times, and say, ‘How much are you going to pay me to tell you who’s going to win tonight?’”

Kenneth French—the Dartmouth professor who constitutes one half of the famed duo behind the Fama-French three-factor model of stock returns, which questioned the underpinnings of the Capital Asset Pricing Model—offers his students that hypothetical as Skill v. Luck 101. And he doesn’t stop there.

“For the average dollar, I found moving from active to passive management would increase returns by 67 basis points per year,” French says, speaking of a landmark 2008 study he conducted on US stock market data from 1980 to 2006. For individuals, that figure would be somewhat higher, whereas the lower investment fees offered to institutions would reduce it slightly. “This is all about cost. If I choose to hold a passive market portfolio, my return is the return on the market minus my costs, and everybody else’s is theirs. So if my costs are lower, I know I’m going to win. And not just over the long term: I’m going to win in literally every instance.”

It’s possible some managers do earn their fees through skill, French says. But guaranteed there are superstar managers—and CIOs—who owe their performance entirely to luck. “If I’m that manager, that track record is all I know: I’ve got this alpha of 6% per year. I’m walking around with my chest all puffed out, hitting on women in bars.”

So how can asset owners pick out the true Celtics savant from the lucky guesser—one whose next game prediction is just a well-paid shot in the dark? French doesn’t know. “Either before or after the fact, it’s an extremely difficult statistical problem. To think that one could learn anything meaningful by looking at three years of securities returns… Well, they’d have to be very peculiar, Madoff-style returns. In reality, the signal-to-noise ratio is about zero.”

Even if skillful managers do exist, French argues that without the tools to identify them, there is no apparent justification to pay for anything but passive in public markets. “If you insist on hiring an active manager,” he says, “at least get someone cheap.”