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Skill, past performance, risk: understanding the fundamentals investors can and can't rely on


If an active fund manager outperforms, most investors believe that's down to skill, when research reveals it's more likely to be a blend of luck and taking on increased risk. In this expert interview discover why investors are manipulated, and how you can look beyond past performance for positive future gains...

Robin Powell: Hello there. Investors over-estimate the importance of skill and underestimate the role of chance in investment returns. That’s the key finding of a study conducted by researchers at the University of Mannheim in Germany.

The study’s entitled "Fooled by Randomness: Investor Perception of Fund Manager Skill". The researchers found that most investors base their decision on which actively managed fund to invest in on past performance. However, they fail to appreciate the extent to which volatility skews returns.

They assume that managers who’ve performed well were skilful, when in fact they outperformed simply because they took on more risk. Here’s Professor Martin Weber:

Professor Martin Weber: If you take the results together and ask yourself “What should I do?”, the first thing is: Don’t look at past returns. And you don’t chase past returns. Period. Most of the time, if you chase past returns, what you pick up is randomness.

RP: Professor Weber accepts there are a very small number of skillful fund managers out there. But, he says, that’s not the point.

MW: The next question would be “Can you find these people? And is it worth it?” And the answer is, it’s very hard. Some people say you have to wait for 100 years in order to find out who’s a skilful manager. Suppose you find a skilful manager: Is he or she worth the money? If you have a skilful manager who is cheap then go for it. But in general, skilful managers are expensive.

RP: So, given how unlikely it is that you or I can identify the next Warren Buffett, why do so many of us try to do just that? For Professor Weber, it’s mainly down to two things: industry advertising and the media.

MW: You have to admit that passive investing is boring. The media has every incentive to write about active. So the news is against us in investing. From the industry’s point of view, passive is much cheaper than active, so why should I promote it when I can earn more money on the active side?

RP: So, next time you’re tempted to buy a particular fund on the strength of an advert or an article in a newspaper, beware. Yes, it might just become a consistent star performer, but the odds are heavily stacked again it. Until next time, goodbye.

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