IN SEARCH OF SKILL
Many readers may, when younger, have dreamed of being a sports star, whether in a team sport such as soccer, rugby, cricket or hockey, or an individual sport like golf, tennis or athletics. Of course, very few of us achieve such greatness.
Importantly, the path to sporting greatness is fairly clear, although for some it may not have been reachable because the cost was too high even if the natural talent existed.
An aspiring sportsperson can receive coaching, read books and in more recent times watch YouTube videos to improve their skills. They can also pursue Malcolm Gladwell’s magic number of 10 000 hours of structured practice to become world class, as per his bestselling book “Outliers”.
However, only a handful of sportspersons achieve greatness. Most give up on their dreams early on because most sports have a very strong feedback loop - you quickly find out whether there is any chance that you have the combination of talent and temperament that makes you exceptional.
A 2014 study from Princeton University provides a different perspective from Gladwell’s “10 000 hours of practice” rule. The Princeton research shows that, on average, deliberate practice explains only 12% of the difference in performance in various fields. What is surprising is how much this depends on the chosen field.
In games like chess, deliberate practice makes a 26% difference, in music a 21% different, in sports 18%, in education 4% and in the professions only a 1% difference.
Possibly the best explanation for this is found in Frans Johansson’s book “The Click Moment.” He argues that deliberate practice is only a predictor of success in fields that have very stable structures. In chess and classical music the rules never change, so you can study to hone your skills. In less stable fields like investing, which is an example of a complex adaptive system, rules can go out of the window.
In implementing an investment strategy, investors need to decide whether to persist with the idea that they can find skilled investment managers. If they reach the conclusion that their chances of doing this are low, they should follow a passive (or index-tracking) strategy. Hope is not a good justification for sticking with active managers!
Those who do believe they can choose skilled investment managers need to consider that less than 20% of active managers are likely to out-perform the appropriate index, net of fees.
To develop a robust justification for active management, investors need to be sceptical of some of the narratives that investment managers tell.
In spite of the hardy disclaimer “past performance is not a good guide to future performance”, investors attach a very high weight to three-and-five-year past performance – this is supported by a 2008 study by Goyal and Wahal, which also shows that, after costs, institutional investors typically destroy value by switching managers.
Past performance provides a very poor “feedback loop” unless measurement periods of at least fifteen to twenty years are used; short and medium-term past performance is as likely to be due to luck as to skill. (And of course, if picking managers was as easy as simply looking at the league table of past performance over three or five years, nobody would need investment consultants!)
If investment managers were completely honest they would be more forthcoming in attributing their periods of strong performance to a mixture of luck and skill, rather than just trumpeting their good numbers. It was refreshing to see Allan Gray put out a note for clients in 2016 explaining why a good proportion of their recent excellent performance was due to luck rather than skill.
Almost all investment managers can present a compelling story of why they are skilful. This is hardly surprising – there are many academic courses that cover investments, of which the Chartered Financial Analyst qualification is probably the most common. There are also plenty of books written by or about investors with excellent longterm performance track records, such as Warren Buffett, Anthony Bolton or Peter Lynch. Of course the authors know that the “secret recipe” to being a skilled investment manager is more than can be found by reading their books, or else they probably wouldn’t publish them!
Investors often try to adopt a seemingly precise scorecard approach when assessing managers. Inevitably the difference between the highest and lowest scores is small, simply reflecting that almost all managers can tell a good story. Investors are therefore inclined to fall back on (recent) past performance, as a seemingly “objective” criterion – deceptive though this usually is.
Our advice to investors is to expect a compelling story from most investment managers, but to recognise that this is not enough. Rather, one should be on the look-out for unusual things that the manager may say. One of the better definitions of a competitive edge is something which is easy to describe, but difficult to copy.
Investment managers will often point out that their interests are aligned with those of their investors. A common line is “We eat our own cooking” - their own money is invested in the same strategy as that of their clients. However, financial success for a manager is likely to be more geared to winning new clients, and thereby earning additional fees, than just to doing well for their existing clients.
By and large, the managers are in a very privileged position in that they receive a fee irrespective of whether they out- or under-perform (even though the fee may be higher for out-performance, using a “performance fee” system). Unless the manager refunds investors for under-performance (which few will agree to), the worst that can happen is that the manager gets fired.
The fact that very few managers are prepared to pay clients back for under-performance implicitly reduces their accountability. All they need to do is explain to clients the reason for the under-performance, as evidenced around the recent Steinhoff debacle. Managers were quick to explain that they did not really get it wrong (i.e. there was no way they could have foreseen that the company’s accounts were fraudulent), but most were silent on how they would share the pain with their clients.
In our view, given this usually asymmetric payoff in favour of the investment manager, fees should be lower. The fact that they are not lower, we believe, reflects a breakdown in market pricing for investment management services - we suggest this arises mainly because the buyers of these services are fragmented, while it is easy for a manager to reference the “market price”, which investors have paid over many years. John Kay of the Financial Times suggests that investors are prepared to pay up for active management because they infer that “expensive must be good”!
We believe that manager fees are often too high, and that fee bases often do not drive enough accountability on the part of managers. We expect strong resistance to change, but we will keep pushing for lower fees to improve outcomes for retirement fund members and other investors.
The price of a particular share or bond represents the collective wisdom of all the market participants, most of whom have a deep knowledge of the markets. One could thus expect the current market price to be a reasonable estimate of the true value of the investment, which is of course the argument for index-tracking.
To out-perform over the long term, after fees, the investment manager needs to have a different view from the market consensus and to be right more often than not. The manager also needs to weight position sizes appropriately, so that the value added by the “winners” more than offsets the loss incurred by the inevitable losers.
In principle it is fairly easy to take a view that is different from that of the market. Common ap- proaches that do this are “contrarian” or “value” investing, based on the premise that the manager will invest in counters that are temporarily out of favour. A company that is deemed to be “temporarily out of favour” will often be facing some controversy, such as regulatory pressures or threats to its business model - it may be operating in a declining industry. Of course, given this uncertainty, there is also a chance it will go out of business.
A truly skilful contrarian or value manager will, over the long term, get the distinction between “temporarily out of favour” and “being wrong” correct more often than not. Managers can get these calls right by luck over short- and even medium-term periods, but to do this over the long term requires rare insight and exceptional talent - markets are adapting all the time, and what worked in the past may become redundant in the future.
Another common approach is to adopt a significantly longer investment horizon than that of the market. Intuitively this is appealing, as it aims to exploit the human foible of seeking short-term gratification. But it will be a difficult strategy for many managers, as this approach will almost certainly result in significant under-performance at times.
Many managers claim to have a long-term approach, whereas their investment horizon is really only three to five years. Truly long-term investors may be thinking about company earnings over the next thirty to fifty years, and hold a view that the market is under-estimating the long-term earnings potential of the business. Of course it requires a very rare talent to get such long-term views right, given the ever-changing nature of the business world.
Other investment managers aim to exploit the behavioural error that makes us slow to incorporate new ideas and to tend to anchor to the past. These managers are looking for secular changes that will be far more sustainable than the market consensus believes. Here too the risk of error is high, and the skill is to spot the new business models that will change the shape of the global economy.
One of the hardest things for humans to do is to admit that they were “plain wrong”, rather than making excuses for the error – and it should be clear by now that being “plain wrong” is a risk that all managers face. A distinguishing characteristic of skilled investment managers is the ability to balance, on the one hand, the intellectual honesty to take a different view from the market with, on the other hand, the strength of character to admit when you have made a mistake.
The manager must also have the temperament to implement ideas effectively. Some investors take on too little risk (and become “closet indexers”), as it is much easier to explain away relatively small under-performance. Others take on too much risk relative to what they know - they are over-confident.
The incidence of over-confidence in the fund management industry is high: naturally, if you are being paid a large amount, you need to soothe your conscience by believing you are smart!
Skilled managers know that taking on risk is necessary to out-perform the market, but are always aware that they may be wrong, and thus need to be open to new considerations - their job is never done.
Our experience is that a number of managers that we regard as highly skilled have been willing to agree to relatively low fees for our clients. Maybe this is because they recognise that they don’t know everything, and so they are willing to charge their investors less!
In addition, almost all these managers have relatively low assets under management, and many are not actively seeking to win new clients. Because they focus on managing client money and not on growing their businesses, they may come across quite poorly in client presentations.
Almost all the investment managers that one encounters will have a good story to tell. Accordingly, when meeting a new manager, it is sensible to assume that they are “average”, because this is indeed what the great majority of managers are. What one is looking for is a competitive edge – something that is easy to describe but very difficult to do well.
The small number of genuinely skilled managers can correctly see things differently than the consensus, more often than not, based on a rare combination of deep research, superior judgement and temperament.Skilled managers seem to share traits of intellectual curiosity, strength of character to admit that they are wrong, a willingness to learn, and an understanding that they do not know enough, which serves only to increase their passion to learn more.
In addition, they are comfortable to be different to the crowd, but always fret that they may be wrong, and so they actively keep an open mind.