Three Longs & Three Shorts

Fund managers are not like sports stars (but don’t tell them)

Fund managers often attain star status after a period of strong outperformance. Indeed, it helps the asset management company’s cause to support that status as it helps its fund-raising campaigns. Given much of the asset management business is now mostly an asset gathering exercise, this is understandable. However, this article focuses on the sustainability of performance (or lack there of) of the ‘star’ fund manager, especially in the context of recent comparisons with sports stars. The author first shows data that highlights the lack of persistency in fund performance which questions the sustainability of the fund manager’s stardom.
“Fund management doesn’t conform to the rules of sport. It just doesn’t.
Take the English Premier League, for example. Yes, there are notable “black swan” events — Leicester City winning the league in 2016 being the most recent example — but you can normally predict at the start of each season at least three or four of the teams that will finish in the top six.
Fund performance bears no resemblance to that at all. As the Persistence Scorecard produced by S&P Dow Jones Indices illustrates time and again, returns appear to be completely random. The March 2019 scorecard, for example, showed that, of the 498 US-domiciled funds that finished in the top quartile over the five-year period ending March 2014, only 16.1% managed to repeat that performance over the five-year period ending March 2019. We would expect 25% to do so from random chance alone. On the other hand, 31.5% of the top-quartile funds fell into the fourth quartile — more than would be randomly expected to do so.
The equivalent, in football parlance, is Manchester City winning the title one year, then finishing 16th, 7th, 14th and 3rd in the following four seasons, and then getting relegated.”
Then he goes onto identifying possible reasons for the lack of sustainability in performance:
“There are several possible explanations for why outperforming fund managers tend to fizzle out. One is that, as they become more popular and attract more clients, the size of the fund grows. They consequently have to broaden their range of stocks, thereby diluting their best ideas. A second explanation is that a “style” of investing that helps a particular manager to outperform for a period of time simply stops working.
But surely the most plausible explanation is that it’s extremely difficult, if not impossible, to distinguish luck from skill in active money management. When you watch a top football team action, their natural ability is plain for all to see. Yes, luck will always play a part — strange refereeing decisions, for example, or injuries to key players. But, over the course of a season, it’s easy to see why a team like Liverpool will finish higher than a team like my own (let’s not go there, all we?)”
The author brings up another dissimilarity with sports stars – which is that the best of sportsmen compete with their peers individually where as the fund manager competes with the collective wisdom of the market, especially given increasingly limited information asymmetry.
“The scale of the task fund managers face is brilliantly explained by Larry Swedroe in his book, The Incredible Shrinking Alpha, by way of a tennis analogy.
At the height of his powers, says Swedroe, Roger Federer was the greatest tennis player of his era. That was despite Andy Roddick having a better serve, Andy Murray a better backhand, Rafael Nadal a better baseline game and so on.
Yet while Federer’s opponents were other tennis players, fund managers are attempting to outwit a far more formidable opponent, namely the collective wisdom of the entire market. Wherever they turn, they’re constantly competing with fellow managers who are very good at whatever it is they specialise in.
As Swedroe says, it’s as if each time Federer stepped on court he faced an opponent with Roddick’s serve, Murray’s backhand and Nadal’s skill at the baseline. If that had been the case he may not have won a single tournament.”