>The Problem With Mutual Fund Manager Skill……Luck or Skill?

>I am not a big fan of using money managers to manage my clients money. It’s not that these people aren’t smart, quite the contrary, its simply the fact that they rarely outperform the benchmarks they should be compared to. Of course a few always do outperform each year, sometimes a few outperform for many, many years. Bill Miller of the Legg Mason Value fund has “outperformed” the S & P 500 now for 14 years in a row. A recent headline read “Bill Miller’s Streak Preserved,” the story had the following comments:

“It came down to the wire, but Bill Miller has done it again. The storied Legg Mason Value Trust fund manager pushed his winning streak over the S&P 500 to 14 years as of today’s close, an unparalleled run.”

“You can’t help but cheer Miller on and hope that his streak says alive,” says Morningstar analyst Kunal Kapoor. “After all, he embodies what a good active manager should be: an independent thinker who invests with the long haul in mind.”

Surely Mr. Miller has skill, right? No other manager has beaten the index every single year for 14 years in a row, right? Perhaps Mr. Miller does have skill, though it is difficult to know as we would expect statistically for at least one money manager to beat the S & P 500 14 years in a row. Now, I am not a statistician, but let me give you an example of what I mean.

Pretend you were in a basketball arena full of people, 14,000 people to be exact. You asked each one of them to pull out a quarter and stand up. Next you ask everybody to flip the coin and if they get tails to sit down. Since the chance of flipping a tail is 50-50 we would expect half to sit down, leaving 7,000 people, what follows is what would happen if we kept this experiement going:

Start out with 14,0000

Flip 1 7,000

Flip 2 3,500

Flip 3 1,750

Flip 4 875

Flip 5 438

Flip 6 219

Flip 7 110

Flip 8 55

Flip 9 28

Flip 10 14

Flip 11 7

Flip 12 3.5

Flip 13 2

Flip 14 1

What does this mean? Well, after 14 coin flips we still have one person standing. This one individual has flipped heads 14 times in a row. Is this individual skilled or lucky? Does he know something about flipping coins that allows him to flip heads everytime, or is it simply luck? As you can see from above, statistically we would expect one person to still be standing, having flipped heads 14 times in a row, it wasn’t any skill on this individuals part, just pure luck. If we asked him to continue flipping an infinite number of times he would eventually revert back to half his flips being heads, the other half tails. He isn’t a gifted coin flipper, just a random person who out of a crowd of 14,000 individuals happened to be the one that flipped heads 14 times in a row.

This little story has two implications for your portfolio. The first, it is very difficult to tell whether your money manager (read: mutual fund manager(s)) have any skill or are just lucky. In fact, assuming there were 14,000 mutual funds in existence 14 years (probably wasn’t that many) we would expect at least one of them to do what Bill Miller has done – beat his index 14 years in a row. Is Bill skilled, or lucky? We can’t know, in fact it would take decades more of him managing money for us to know with certainty if he is skilled, by then it is too late.

The second implication is that we had no idea who the guy was that was going to flip heads 14 times in a row, in advance. In other words, if you were standing in the middle of the stadium and asked to identify which person would flip heads 14 times in a row would you have a very good chance of identifying him/her in advance? No, it would be nearly impossible. The same goes for mutual fund selection. Even though we know that statistically somebody each year will outperform, and we know that over periods of time somebody will outperform we don’t know who it will be in advance and we have no way of predicting – thus spending our time attempting to do so is a waste. We are spinning our wheels.

Next time you flip a coin think of the implications it has for your portfolio, are you basing your retirement on chance and luck? Active management and attempting to pick winning money managers is akin to spinning your wheels, it gets you know where.

Until next time……

ScottyD

PS – I ended up watching the half time show of the super bowl (what an improvement over last year)and the rest of the game, it was a good game, but since I really didn’t care who won I was mainly watching for the commercials. The guy with the spaghetti sauce, knife, and white cat cracked me up, but the Anheiser Busch commercial is the one that choked me up. If you didn’t see it was a thank you to the men and women who are putting their lives on the line to protect our freedoms (and that of others). My three year old (who now has memorized and says the pledge of allegiance everyday) was watching the game with me and I pointed to the TV and started to say “these are the men and women who are giving their lives for us,” but I couldn’t get the words out, I started to choke up and my son looked at me in bewilderment. The commercial was simple, a bunch of troops walking through an airport after getting home from being deployed…..everybody in the airport (including the janitors, cooks, & security) stood up and started clapping for them. I tear up just thinking about it. My son may not understand the depth of the commercial (especially in its simplicity), but somehow I think he knew by my reaction that these people where worth knowing about and paying tribute.

Nothing I can do is enough to thank our wonderful men and women (and families) who give up themselves everyday, but perhaps I can instill in my children the honor that they bring to our country and what they represent…….Freedom. If you are interested, Michael W. Smith has a great song that he wrote after 9/11 entitled “There She Stands” it is truly a classic and what inspired me to teach my son the Pledge….now if I could only get him to say the ABC’s outloud (he knows them…..).

ScottyD

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