Skill Tomb Stone

Is Skill Dead? Perhaps It Was Never Alive

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Skill Tomb Stone

A recently released white paper from GMO titled “Is Skill Dead?” begins with this excellent quote from Jeremy Grantham: “90% of what passes for brilliance or incompetence in investing is the ebb and flow of investment style.” Our only argument with that statement is that we think the number is closer to 100%. One academic paper that we cite very often puts it at 99.4%, as shown in the pie chart below.

The authors of the white paper note that in 2014, between 80% and 90% of active U.S. equity managers underperformed their benchmark, making it an especially bad year for active management. Citing a figure of 83% of domestic large cap equity managers that lagged the S&P 500, the authors attribute underperformance to style drift and cash drag. In addition to having a cash reserve (either for market-timing or to meet redemption requests), most active large cap equity funds also have exposures to international and small cap stocks, and in 2014, all of these deviations worked against those managers. The authors went on to show how the “ability to add alpha” over the last 25 years of large cap managers is largely explained by these three deviations, and they even went so far as to create their own 3-factor model based on these exposures. While we have no problem with their methodology, and we completely agree with them when they say, “Extrapolating a short-term trend into the future can be a very difficult way to compound wealth,” we do take issue with this statement regarding the “merits” of active management:

“Active management allows for the continuous assessment of the state of the market and to make intentional choices about how best to take advantage of opportunities and mitigate risk. Passive management precludes the ability to add value in this way.”

For us, a reasonable question to ask is how good of a job have active managers done in assessing the state of the market, taking advantage of opportunities, and mitigating risk? The answer we continuously see (such as here) can be summarized as “not so much.” Also, a well-designed passive portfolio strategy will take advantage of the various risk and return dimensions of the market while mitigating risk with high-quality, short-term bonds. To summarize, in a highly efficient market, the skill or talent of a single manager is not a reliable source of long-term returns. This does not preclude the presence of skill in overall portfolio construction. If you would like to learn more about how IFA builds risk-appropriate portfolios for our clients, please call us at 888-643-3133.