John Husselbee: Differentiating between luck and skill

To channel Dirty Harry, how many of us consider ourselves lucky?

For something that, by definition, has no basis in fact, luck plays a huge role in many cultures around the world. In China, for example, people believe certain numbers, colours, animals, days, and actions are more favourable than others. Red is the national colour, representing happiness, wealth, prosperity, and good luck, while dragons and tortoises are considered auspicious beasts.

Like so many things, the concept of luck gets trickier where money is involved and this is certainly the case when it comes to the debate around active fund management. As we have written in the past, recent high-profile blow-ups have allowed a narrative to develop that active managers are little more than ‘coin tossers', with luck playing a huge role in the returns for which investors pay considerably higher fees than for passive alternatives.

When the winds of change blow, some people build walls, others build windmills. Active fund management is clearly facing down some gales in 2020 and beyond, but we feel there remains plenty of skill to be found if you know where – and how – to look

This debate has prompted us to look into this luck versus skill question in more detail: after all, interviewing and assessing fund managers is a huge part of what we do on a day to day basis.

First off, we can all acknowledge there are a few superstitions when it comes to fund management - the old ‘sell in May and go away' mantra, for example. 

A much deeper question - and one the active fund industry must work to prove in the coming years - is how far investment returns can be split into luck and actual manager skill. If you look on a spectrum from the pure luck of a lottery win at one end to the skill of an individual sport like tennis at the other, where does fund management sit?

As would be expected - we are part of an active house at Liontrust, after all - we feel it is very much towards the skill end, but it is important to differentiate between the short and longer term here.

For us, this difficulty in differentiating luck from skill in the short term comes from various external variables, including investment style (growth versus value), market cap bias and basic market noise, of which there has been plenty in recent years.

Looking at win/loss ratio data for one of the top-performing UK equity funds, it has a 52% win/loss rate against the IA UK All Companies sector if you look at one-month rolling returns. That fits a coin-flip, luck-not-skill template. But this goes up to 93% versus the sector if you look over rolling five-year periods and 100% over rolling ten-year periods.

Mean reversion is also far less pronounced over longer timeframes and it is easier to extrapolate future success based on more information.

Given all these factors - and the clear prevalence of luck in the shorter term - we continue to question why so many investors buy funds on the back of a three-year track record. Ultimately, our sweet spot is to find skillful managers who have been ‘unlucky', whether based on style or market cap focus, for example.

As our investors will know, a key mantra behind our process is that while consistency of performance is ultimately impossible for fund managers over every time period, consistency of process is a must for all those we select. 

Indeed, trying to predict the future is challenging and ultimately a fool's errand: ten years ago, anyone suggesting we would be entering a new decade with a Trump/Johnson tandem leading the US and UK would have been told to go and lie down in a dark room. What we can say is that it is possible to identify fund managers that have shown the capacity to outperform over long periods of time and that is clearly skill rather than luck.

To bring things back to China, a famous proverb goes as follows: when the winds of change blow, some people build walls, others build windmills. Active fund management is clearly facing down some gales in 2020 and beyond, but we feel there remains plenty of skill to be found if you know where - and how - to look.

John Husselbee is head of multi-asset at Liontrust

This article appeared in the April issue of Professional Adviser's bi-monthly sister title Multi-Asset Review. To make sure you receive your own copy of the next issue, please register your interest here

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