Luck plays a far bigger role than skill in investment performance
The news media are drawing all the wrong lessons from Meredith Whitney’s decision this week to close down her hedge fund.
To be sure, the media are right to point out that Whitney, after a spectacularly correct forecast at the top of the bull market 2007 that banking stocks were due for a big drop, was spectacularly wrong several years later when she forecast massive municipal bond defaults. And, yes, performance at her hedge fund, Kenbelle Capital, has been disappointing.
But the real story here is why anyone is surprised.
That’s because most investment success — not just Whitney’s, but any adviser’s — is due overwhelmingly to luck rather than skill. So what truly would have been surprising is if Whitney’s fund had actually performed well.
UCLA finance professor Brad Cornell has proposed a simple formula for gauging the relative investment importance of skill and luck. Upon applying that formula to a large sample of mutual funds, he found that 92% of the differences in those funds’ annual returns was “attributable to random chance.”
I reached a substantially similar conclusion when applying Cornell’s formula to the several hundred investment advisers monitored by the Hulbert Financial Digest.
What that means in practice: Top-ranked performance in a given year is rarely repeated the next year. If you’re an adviser lucky enough to have made a call as great as Whitney’s in 2007, the rational response is to market the heck out of your track record before your hot hand cools, which it almost certainly will.
So Whitney was behaving entirely rationally when, in the wake of her remarkable 2007 call, she quit her job as Wall Street analyst and started her hedge fund. What’s irrational has been the response from the rest of the world to her fund’s disappointing performance and recent decision to close it.
I’m not picking on Whitney in particular, by the way, since the dismal odds she faced are no different than for any other adviser. Just ask Bill Gross, the superstar bond fund manager who left Pimco last September to begin managing a new bond fund at Janus. While at Pimco, Gross produced one of the most impressive bond trading records in modern history. Since then, according to Morningstar data, Gross’ new fund has lagged a buy-and-hold strategy by 2.2 percentage points.
Or take Bill Miller, the famous manager at Legg Mason Value Trust who beat the S&P 500 for 15 straight years through 2005. At the time that certainly looked like something that couldn’t be attributed to mere luck. Yet from 2006 until 2012, when he stepped down from the fund, Miller’s performance was so far behind a buy-and-hold strategy that he ended up lagging a simple index fund over the entire period when he managed the fund.
Note carefully that I am not saying there is no such thing as investment skill. If we accept professor Cornell’s finding, for example, 8% of an adviser’s superior performance is due to genuine skill. The corollary of this small role played by skill, however, is that it takes many, many years for it to win out over luck.
A gambling analogy is appropriate. Though a good card counter in blackjack is able to get the odds arrayed in his favor, he still must play many rounds in a row to have a fighting chance of beating the house. Unfortunately, while you can play many blackjack rounds in a single evening, a “round” in the investment game lasts months, if not years.
Therefore, it would have taken a very long time — well more than decade — for Whitney to have produced superior performance at her hedge fund. Neither she nor her investors had the patience to wait that long. On the contrary, as she said on the Fox Business Network, “this whole experience has been highly unfortunate, and I’m putting it behind me.”
The huge role played by luck remains investment advisers’ dirty little secret. Off the record, many concede its truth. But on the record, they feel constrained to deny it, insisting that it is skill that plays the predominant role, and expressing that they are “shocked, shocked” that they were unable to repeat a previous period’s market-beating performance.
If we finally learn to appreciate the huge role played by luck, then perhaps Whitney’s “unfortunate” experience will not have been in vain.