I often get questions about different money managers. The majority of times, people ask my opinion about a specific money manager that has had an exceptional past track record.
Some of these questions are asked purely out of curiosity and others are more pointed such as, “Would it make sense to invest some money with this manager?”
Before I get into further details, let me point out that my definition of a conventional money manager is someone who tries to pick individual stocks, time the market, or a combination of both as a way to improve returns. Put another way, they are basing their investment decisions on predictions and forecasts.
I fully believe that there are very smart and skilled money managers out there who can beat the market and add significant value.
Here is the problem…
The vast majority of money managers charge too much for this perceived “skill” and perhaps more importantly, it is very difficult, if not impossible to choose these smart and successful managers in advance of their great performance.
Let me explain this further by giving you an example about a trip to a casino … something I am sure everyone can picture, even if they haven’t experienced it directly.
Costs – a case of simple arithmetic
Nobody should be surprised to learn that the odds of every single game in a casino is stacked in favour of the house. If they weren’t, why would anyone spend a billion dollars building a new hotel and casino? They are not being charitable; they are doing this to make money.
From a business perspective, these favourable odds can be equated to a profit margin for the casino owner and a cost for the gambler. For the casino business as a whole to be viable, there has to be more losing gamblers than winners. That is not to say that everyone going to a casino will lose, but if you add up all of the gamblers in total, there has to be more losers than winners.
From an expectations point of view, any individual going to a casino should expect to lose money. That said, the reality is that there is a group of people who know this and would never set foot in a casino. There is a second group that knows this fact, but will go to a casino anyway and consider any losses as part of the entertainment value. And finally, a third group that go to a casino with an expectation of beating the odds by winning consistently. Statistically, we call this third group delusional.
Now, let’s turn this to the financial markets. If we choose an asset class, like Canadian stocks, in aggregate the return of all Canadian stocks will equal the collective return of all participants who invest in Canadian stocks, less costs. Therefore, the expected return (i.e. return in the future) of any individual participant (including all money managers) is the return of the asset class less their individual costs.
The take-away here is that in aggregate, higher costs equal lower expected returns. Put another way, by including costs there has to be more losers than winners … nothing magical here, it is just simple arithmetic.
But I only pick the good money managers …
I have never met anyone who hires a money manager that has underperformed the market; they just focus on the winners.
The rationale with this approach is that if a manager has out-performed in the past, it is a good indication that they possess some “skill” and will be able to continue this into the future.
The problem with this is that extrapolating historical data into the future ignores the important issue of whether this past performance was accomplished by skill or just luck?
Skill or luck, why does this matter? Shouldn’t the track record speak for itself?
The reality is that skill or luck matters a whole lot going forward because the costs of getting this wrong can be significant. For individuals, it can be the difference between meeting their financial goals or not.
Let’s go back to our casino example. Suppose you were watching a game of roulette (or any other game of chance) and you saw someone win 10 times in a row. Would you then infer that this person must possess some unique gambling skills? Would you take this a step further and give them your money so you can profit from their superior gambling skills? Of course not, the only rational inference is that they were lucky.
When I use the above example, it seems pretty obvious. The mystery of course is what so many investors ignore – the role of chance in financial markets – and automatically assume all great track records are based on skill alone.
I want to point out that the intent of this article is not to be a dissertation on statistics and probabilities. If you want to dive into more details (and data), please download our recent whitepaper called Structure Trumps Trading and/or Switching.
When someone comes across a hot money manager, there are 3 options … just like going to a casino.
Choose not to play (or not to invest with conventional money managers ). Know that higher costs matter and you cannot dis-entangle luck versus skill. A much better approach is to use low cost asset class funds or ETFs to capture market returns. You can go a step further and use scientifically proven factor exposures, such as size, valuation and profitability, and capture excess returns above the market.
Invest with a conventional money manager based on the entertainment or cache value. No one would debate the great feeling (and boost to your ego) if you picked a manager today and they had great performance going forward. The practical issue is the cost of this entertainment. For example, if on average a conventional manager charges 1% more per year, on a million dollar portfolio, that equals $10,000 per year compounded annually. That is a big price to pay for entertainment value.
Invest with a conventional money manager because you think they can add value. This option is similar to the group that goes to a casino with the expectations of beating the odds. The reality is: either this group doesn’t know the odds are stacked against them or they know the odds and have chosen to ignore them. For some financial advisors, there is also an agency or compensation bias to their advice to choose this option, but that is a topic for another time.
Think about your personal experience at a casino and think about what you are trying to accomplish with your financial assets. What will you do the next time you hear about a hot manager?
Personally, I have been advising clients to choose Option 1 for the past 10 years … which has turned out to be some of the best financial advice I have ever given.