The Big Question: Are Successful Active Managers Lucky or Skilled?

(upbeat piano music)

Hal Weitzman: A couple of years ago, a British newspaper pitted the investing skills of three experienced money managers against Orlando, a ginger cat. Each group was given an imaginary £5,000 to invest in stocks. After one year, the money managers had made a profit of £176. Orlando had made £542.

So is investing in financial markets merely a matter of luck? Or do active managers, in fact, have some insight into which stocks will outperform the broader market? Investors are usually recommended to put their money in broad stock market–tracking funds and leave them there for a long time. Yet some active managers actually seem to be able to beat the market most of the time. So are they just lucky? And if money managers really are becoming more skilled, why aren’t returns improving too?

Welcome to The Big Question, the monthly video series from Capital Ideas at Chicago Booth. I’m Hal Weitzman, and with me to discuss the issue is an expert panel.

Lubos Pastor is the Charles P. McQuaid Professor of Finance at Chicago Booth. He’s a research associate at both the National Bureau of Economic Research and at the Center for Economic Policy Research and an associate editor of both the Journal of Finance and the Journal of Financial Economics.

Juhani Linnainmaa is an associate professor of finance at Chicago Booth. His research focuses on investor behavior, asset pricing models and portfolio choice, and mutual fund performance.

And John Rekenthaler is vice president of research at Morningstar, the investment research and investment management firm. A Booth MBA, he’s been with Morningstar for 25 years serving in various capacities, including vice president of new product development and head of the company’s retirement advice business.

Panel, welcome to The Big Question.

Lubos Pastor, let me start with you because your research is kind of making this claim that managers have skill. They’re becoming more skilled over time. And yet, your colleague Gene Fama just won the Nobel Prize for a body of work that suggested that the stock market was pretty much random in its movements, and so managers who outperform the market are really just lucky. Those who underperform are unlucky. Are you trying to overturn that body of work?

Lubos Pastor: Not really. I do believe that managers have skill. Yet skill does not guarantee superior performance.

So if you’re a skilled manager, that doesn’t mean you’ll be able to beat the market.

Hal Weitzman: OK. And so how do we define skill?

Lubos Pastor: I think of skill as the ability to identify good investment opportunities, for example, the ability to find mispriced securities. OK. Now, being skilled doesn’t mean that you’re necessarily able to beat the market, and the reason is competition. So I may be skilled. You may be skilled. That doesn’t mean we’re gonna beat the market because Juhani here may be even more skilled and he will find the mispriced security before you and I do. And so we won’t be able to capitalize on that skill.

Hal Weitzman: OK, so is it actually the case that it dovetails quite nicely with Gene Fama’s work, with this idea that there’s mispriced securities and some more skilled manager comes in and takes advantage, that makes the market more efficient overall?

Lubos Pastor: Exactly. This idea that active managers have skill is not incompatible with market efficiency. It could exist with or without market efficiency.

Hal Weitzman: OK. Juhani Linnainmaa?

Juhani Linnainmaa: Yeah, I will go back to the point about Gene Fama’s work and how it relates to Lubos by saying that his view that the average active investor can’t beat the market, that should be completely uncontroversial because if you look at all the investors in the world–

Hal Weitzman: The average investor cannot—

Juhani Linnainmaa: Yeah, the average investor, because if you look at all the investors in the world, collectively they are just holding the market, so they must be earning the market return. But nothing says that there couldn’t be any skilled investors out there. It just means that if there are any skilled investors, they must be making money at the expense of other investors.

Fama’s rule about active investing and the impossibility of beating the market, that can apply to, you know, I guess the average investor. If you don’t have any special skill or information advantage, then you don’t want to be active in the markets because then you’re just going to be providing returns to other investors and you’re gonna be lagging in the market yourself.

Hal Weitzman: I see. John Rekenthaler?

John Rekenthaler: Yes, well, at Morningstar, we’re often asked to run numbers to, say, answer the question: Do managers have skill? And we’ll run the numbers. You see the typical mutual fund category, the typical fund will perform about like it’s the market index that it’s tracking minus the expenses. In other words, it pretty much tracks the index when you net out the expense ratio, consider the expense ratio.

The difference with this paper is it doesn’t stop there. Most people say, OK, managers just don’t have skill because they just match the index. And Lubos’s paper, which is an unusual angle to take, says, wait a moment. They’re not able to beat the index, but that doesn’t mean they don’t have skill. Because after all, the people they are competing against also have skill, are trained in investment analysis, and so forth.

So let’s try to sort of separate these two questions: Can they beat the market? And do they have skill? Usually those two questions are put together.

Hal Weitzman: Right, but it seems confusing. We’re talking to . . . make this clear, we’re talking about a paper that you’ve written: “Scale and Skill in Active Management.” So if we can’t measure skill by whether or not you’re beating the broader market, how do we measure skill?

Lubos Pastor: Well, we have to measure skill by looking at performance, which is your ability to beat the market, but then adjusting it for skill. So we measure skill as performance adjusted for scale, where scale is a measure of competition.

So in particular, we measure skill as the manager’s alpha or the average benchmark-adjusted return adjusted for the size of the industry in which the manager operates. The idea is that if you operate in a larger industry, you face more competition. And so it becomes harder to find mispricing—

Hal Weitzman: So just unpack that a little bit. We talk about the relationship between skill and scale. So there’s something deadening about scale in terms of returns.

Lubos Pastor: Yeah. Scale is not good for performance, and there are at least two kinds of scale that are detrimental to performance. There’s fund-level decreasing returns to scale and there’s industry-level decreasing returns to scale.

At the fund level, the idea is that a larger fund finds it more difficult to outperform because its trades have a larger price impact. So that hurts performance.

Hal Weitzman: So broadly, let’s say you’re buying, you know, a million shares as opposed to 10,000—

Lubos Pastor: Precisely, you’re gonna move the price—

Hal Weitzman: The price.

Lubos Pastor: Yeah. And at the industry level, the idea is that the larger the industry is, the more dollars are chasing mispricing. So mispricing becomes harder for any given manager.

Hal Weitzman: So the growth of, let’s say, in this case we’re talking about active fund management is actually a problem for fund management performance?

Lubos Pastor: It is. It is because it makes it more difficult for active fund managers to beat their benchmarks.

Hal Weitzman: OK, John Rekenthaler.

John Rekenthaler: The way I think about the paper is if you took the typical active fund manager of today and put that manager back in 1979 or 1985, hot tub time machine, right. That manager’s going to town. That manager is better trained, better equipped. Much easier competition.

And in fact, when you go back and look in the 1970s and 1980s, there used to be quite a few funds that were stopped once and routinely beat the market because they had the equivalent of today’s managers. There were a few of them back then. Unfortunately, that manager has to operate today when the competition is much much tougher.

Hal Weitzman: Right. Juhani?

Juhani Linnainmaa: Yeah, I think Lubos’s point about scale and competition seems to make a lot of sense.

So if you look at very long-term trends in who participates in financial markets, you can see that the share of individual investors has been decreasing dramatically. So if you look at 1970s and 80s, if you went to the market, you often end up trading as individual investors. And so as long as you had more skill than the average individual investor, your skill could translate into superior returns.

But in today today’s markets, when most institutions . . . when most assets are held by institutional investors, some of them quite sophisticated, it’s much more difficult for you to make money in the market because everybody else that you’re trading against also has skill.

Hal Weitzman: So there’s more smart money and less dumb money, is that it?

Juhani Linnainmaa: Yeah.

Hal Weitzman: John, go ahead.

John Rekenthaler: And I’d like to point out this is an argument that has been made outside of academic circles among institutional investors and consultants for a long time now. There’ve been a lot of articles that have more anecdotally argued that it’s getting harder and harder for active managers to . . . it’s getting more . . . their jobs are getting more difficult because so many other people are well-trained and and the competition levels are higher.

I just hadn’t seen, you know, a paper try to quantify this. To me, that was the difference. They’re trying to quantify something that before was anecdotal.

Hal Weitzman: So let’s get to the quantified bit. What proportion would you say money managers are skilled in the sense that you describe it?

Lubos Pastor: The vast majority of them. We have two different econometric specifications in our paper. According to one of them, three-quarters of the managers are skilled. According to the other, it’s even more.

Hal Weitzman: OK, does that sound right to you, Juhani?

Juhani Linnainmaa: I guess that depends on whether you measure the skill that the managers have or whether you measure the skill from the viewpoint of investors.

So I think for the numbers Lubos has in mind, it’s not about the returns attained by the investors. Do you have an estimate of that? Like, if you randomly pick an active mutual fund, what’s the likelihood that that manager is gonna have positive alpha?

Lubos Pastor: Positive net alpha? Yeah, we did not look at that. Absolutely.

We looked at it from the perspective of whether you have skill, whether you’re able to deliver. Will you be able to beat the market on your first dollar, essentially, first dollar invested? Regardless of what the investors get.

And you’re right, investors . . . not much of that skill trickles all the way down to investors.

Juhani Linnainmaa: I think it’s completely uncontroversial that the average actively managed mutual fund or the dollar invested in the fund loses the market and that the median fund has a negative net alpha.

So and that’s ultimately what matters for investors because it means that if you randomly pick an active mutual fund, you are going to be lagging to the market. Based on my own work, I would estimate that something like 10 to 15 percent of managers have skill, meaning skill that you can earn superior returns by investing in that active fund.

But now that numbers kind of low—

Hal Weitzman: And when you say that you can, you mean the typical investor, the average investor can put money into 10 to 15 percent of managers that will give them more than the market?

Juhani Linnainmaa: Put differently, that if you just randomly choose an active mutual fund, there’s a 10 to 15 percent chance that you’re gonna get the positive net alpha on average.

Hal Weitzman: I see.

OK, John.

John Rekenthaler: Both those numbers match up. I mean that right? These arguments are on somewhat different paths, but they can come together, which is as I talked about before: the typical fund is going to perform about like an index minus expenses.

So the typical fund will have negative performance and negative alpha, with some that are positive, 10 to 15 percent if you select randomly. You can do a little bit better than that by looking at some other things, but that doesn’t negate the possibility that the vast majority these managers might be skilled, just not be able to outperform the other managers.

Hal Weitzman: OK, and you talked about the hot tub time machine—

John Rekenthaler: My favorite movie!

(panelists laughing)

Hal Weitzman: We’ll have to talk about that in another The Big Question.

So have these skills grown over time? I mean, the proportion of money managers who are skilled has grown over time?

Lubos Pastor: Yes, according to our estimates, there’s no doubt about that. The active management industry has become more skilled over time. Every decade, you see an increase in the whole distribution of skill, especially at the top. But the whole distribution is shifting up.

Hal Weitzman: And so how do we explain that? What’s happening?

Lubos Pastor: So we’ve looked into this. We have some partial answers. It looks like there’s some learning on the job taking place, but more importantly, the new funds coming in, the new entrants in the industry seems to be more skilled than the incumbents.

Hal Weitzman: Right, I see. OK. So it’s not so much that people are getting better while they’re in their job. It’s that better people are coming in.

Lubos Pastor: It’s a bit of both, but the second effect seems more important.

Hal Weitzman: OK, John, is that what you see in the market from—?

John Rekenthaler: Well, one of the explanations is the wonderful graduates that Booth is putting out.

Hal Weitzman: Naturally.

John Rekenthaler: (laughing) Yes, um, it’s true that you see the newer funds performing well. I think it’s difficult to separate the effect . . . the newer funds do tend to be run, although not always, by younger managers. But they often are newer strategies too.

So one could argue somebody’s devised a newer strategy that despite, you know, the person that’s managing it, but perhaps this particular strategy, some sort of back-tested quantitative approach or something that’s newer at least has a temporary advantage.

So it can be difficult to separate some of these effects.

Hal Weitzman: OK, Juhani, do you have a different explanation?

Juhani Linnainmaa: No, not really. I was just going to go back to Lubos and say that there’s this strong market discipline mechanism that the market is not gonna be tolerating bad performance for a long time. So if you have all managers who are not delivering good returns, they’re gonna be wiped out from the market—

Hal Weitzman: You mean people just don’t invest with them?

Juhani Linnainmaa: Yeah the money’s gonna flow out and they’re gonna die out, and then new funds are gonna fill the void, and so you’re gonna see this shift up in the skilled distribution.

Hal Weitzman: Although as you suggest, Lubos, and research that was done prior to your work also suggests that it’s sort of a catch-22: the more successful you are, the harder it is to be skilled in terms of your returns, right?

Lubos Pastor: Yeah, the more successful you are—

Hal Weitzman: More money flows to you.

Lubos Pastor: the more money comes in, right. And as we touched on briefly earlier, it is more difficult for larger funds to outperform.

So back to Juhani’s point. So I mentioned that entry might be the reason why skill is going up. It’s the entry of new skilled funds, and Juhani points out that the exit of bad funds could also be responsible, and I think both effects are likely to be to be going on.

If you look at the total number of funds in the industry, it’s been growing steadily, so that’s what makes me feel that entry is probably quantitatively more important than exit. There’s been a lot more entry then

Juhani Linnainmaa: Yeah.

Lubos Pastor: than exit.

Hal Weitzman: And before we get back into the hot tub to come back to the present, I’d just like to ask one more question. So what about the underperformers, Lubos? Are today’s underperformers still better than, kind of, you know, the median manager was 30 years ago, whatever?

Lubos Pastor: Yeah, that goes back to John’s point earlier. I do think if we had a time machine and took a below-average manager today and transported him or her in the 1980s, that manager would rock. That manager would know about momentum investing, profitability-based investing, accruals, all kinds of things that people in the ’80s had no idea about. And that manager would beat the market.

Hal Weitzman: What about technology? How much has technology improved skill? In other words, how much is it not necessarily the money manager himself or herself but the technology they have access to?

Lubos Pastor: Yeah, technology is there for everybody to grab, so it’s a matter of who is better able to leverage this new technology, and there’s an argument to be made that the younger managers who grew up with the technology might be in a better position.

Hal Weitzman: But the reason I think of it is it sounds sort of similar to what you were saying earlier. In the early days of high-frequency trading, you know, those who had access to the technology did much better. Now that everyone has access, the profitability is gone down considerably.

So I just wonder if technology has any effect in raising skills and the way that you measure it.

Lubos Pastor: Yeah, we have no direct evidence on that. It’s plausible. We just don’t have evidence.

Hal Weitzman: John.

John Rekenthaler: Well, when I started at Morningstar back in the 1980s, you did see some mutual funds that seemed to succeed because of superior technology. some of the largest investment companies had invested in supercomputers, and they were crunching data faster. I think that . . . everybody’s got access—except for the high-frequency traders—but you know, for normal investments, the idea of having a technological advantage over other investment firms is gone. So that’s one thing that’s been arbitraged away.

Hal Weitzman: OK. Lubos, the big question, I guess, for the average investor is if the managers are becoming more skilled all the time, why aren’t we seeing better returns, returns improving along with the skills?

Lubos Pastor: Because competition is growing as well. So skill is improving, but at the same time, the industry is growing. So there are more and more dollars chasing mispricing, and it becomes more difficult for these increasingly skilled managers to outperform.

Hal Weitzman: What about fees? What role do fees play in affecting how investors are impacted by this increase in skills?

Lubos Pastor: Well, fees haven’t really trended up over time. I mean John can speak to this as well. Juhani too.

Lubos Pastor: I don’t think fees have really gone up. Fees may have gone down, but in general, yeah, fees are the wedge between skill and what investors get in the end, and it appears that, that skill is in short supply. So these managers are able to extract most of the surplus for themselves as opposed to leaving it for investors.

Hal Weitzman: John, what’s your view on after-cost performance of fund managers?

John Rekenthaler: The irony of this topic is as managers become more skilled, if we accept Lubos’s thesis, investors are much more skeptical about the existence of skill because they only see it at the final .00, where Lubos is measuring. And so actually, in the mutual fund industry, there is a tremendous amount of fee pressures with exchange-traded funds coming in, index funds. And if you look at the average dollar now, it’s going into much lower cost funds than it did 10 or 15 years ago.

So people are . . . they’re not investing as if they believe in skill, at least in skill that can translate to returns for them. So it’s um . . . there’s been a dramatic change in people pursuing lower-cost funds. You actually have a barbell where at the mutual fund level, people are buying as cheaply as possible, and then hedge funds haven’t really changed their price, and they’re all expensive.

Hal Weitzman: But how does that . . . So if the argument is, though, that the more successful managers, the money flows to them; the less skilled ones, the money flows away. If once we mix in fees, how does that change that argument, John?

John Rekenthaler: Well, you can still be a skilled and successful manager associated with a low fee actively. In fact, I think there is a relationship because many of the biggest firms have relatively low fees. That’s how they become the biggest firm, and they have the volume to be able to do that. So they attract skilled managers. Unfortunately, they attract a lot of money, so, which is not great for the investor, right, because then the scale—

Hal Weitzman: But does the converse apply, that you can attract money even though you’re not so skilled by having low fees?

John Rekenthaler: Ah yes, I think that would be true because people are looking at the after-cost performance of funds.

Hal Weitzman: OK.

John Rekenthaler: It’s not a huge effect. It’s just a modest effect. But yes, that could be true.

Hal Weitzman: OK.

Juhani Linnainmaa: Yes, yeah, I would just add that by saying that when we think about money flowing in and out of mutual funds that have skill or don’t have skill, the money flow is responding to the performance that accrues to investors. So it’s not really about the intrinsic skill of the manager that Lubos is measuring. It’s more about the expected net alpha of the fund. And you can have a good net alpha if you have skill, or if you have low fees, so you can also attract more money.

Hal Weitzman: So you could compensate for not being that skilled by being cheap.

Juhani Linnainmaa: Yep, that is correct.

Hal Weitzman: OK. I wanted to ask you because you study, you know, sort of typical investor behavior. If the managers are becoming more skilled, are the investors becoming more skilled at picking their managers?

Juhani Linnainmaa: (laughing) Yeah, I don’t have anything to say about that. We don’t have good data on looking at how investors make a choice between actively managed mutual funds. There is a bit of research on the attributes that are shared by good money managers.

Hal Weitzman: OK, so tell us a bit about that.

Juhani Linnainmaa: Yes. Actually, some of the great work in the early 1990s from Chicago looked at characteristics like age and education, and they found that young managers and managers with MBAs and managers who went to undergrad institutions with high SAT scores had better performance.

Hal Weitzman: With high?

Juhani Linnainmaa: Higher SAT scores.

Hal Weitzman: OK.

Juhani Linnainmaa: Had better performance. And there was some interesting follow-up work, for example, that said that it’s not the SAT score that matters because it tells you about your intrinsic ability. It’s more about social interactions. That you’re not going to be a good manager because you went to the University of Chicago. You’re going to be a good manager because you went to the University of Chicago and you created all these connections between future managers and future CEOs. And those are going to translate into higher returns in the future.

So there are lots of attributes that have this significant statistical link with future performance. The only downside is that if you look at the variation that you can explain with those attributes, it’s going to be kind of a small number, like 4 or 5 percent. So it means that if the fraction of skilled managers is something like 10 to 15 percent, those attributes like your education and age are not going to be useful to you in identifying the managers who lie in the right tail of the distribution.

So even though we know that there’s some valuable characteristics, they’re not gonna solve the problem for you.

Hal Weitzman: I see. John, do you have any view about investors and how they’re picking managers? How should they pick managers?

John Rekenthaler: Well, I’ve seen that working at Morningstar. Things have changed quite a bit. I would say for the better. When I started at Morningstar in the late 1980s, there was a lot of money flowing to funds that had maybe one or two years of very good performance. Often they were newer funds. They didn’t have a long track record. They’d have a year to attract a lot of money. And they also tended to be very often sort of theme funds or sector funds, or kind of money would flow into this sector or that sector.

And that’s pretty much all gone. If you look at the flows now, they’re into broad-based funds, very often index funds, low-cost funds, long track record.

So it’s really gone from an emphasis on short-term performance to long-term risk-adjusted performance, which I think is better for the investor. There’s certainly been a change.

Hal Weitzman: OK. Lubos, do you have a view on how investors should pick their money managers? Whether they’re any good at it?

Lubos Pastor: I wrote a paper 10 years ago in which my coauthors and I found a way of identifying managers who are actually more likely to do well in the future. We called it “Judging Fund Managers by the Company They Keep.”

So it turns out fund managers who buy the same stocks as the Warren Buffetts of the world—so the managers with excellent track records—and sell the same stocks as the Warren Buffetts of the world in the same quarter, those managers tend to do better going forward. So there are ways—and that’s in addition to the attributes that Juhani already mentioned—I think there are ways one can use the information out there, from Morningstar or from other sources, to identify these better-performing managers.

I also want to add a bit that it actually makes some sense for investors to chase past performance. You know, people often talk about money chasing performance in a pejorative sense. And I’m sympathetic to that view if you want to buy gold after gold has gone up and sell stocks after stocks have gone down.

But in the . . . if you’re reallocating capital across managers, it actually makes some sense to chase past performance because we don’t really know how skilled the individual managers are, and we learn about it by observing their performance. So if we see a manager doing unusually well, well that’s quite possible it means that the manager isn’t managing enough money to eliminate his or her performance, and we need to put some more capital right there.

So I think it makes some sense for investors to chase past performance

Hal Weitzman: OK, John.

John Rekenthaler: Just to clarify. Lubos, you’re talking about chasing past performance within a given type of investment or asset class, right?

Lubos Pastor: Exactly.

John Rekenthaler: as opposed to, as you say, sell the bad performing asset and buy the good performing, which is what we see that’s how people use mutual funds unsuccessfully. That’s the worst thing about the fund industry that we have yet to fix. They’re buying good funds within a particular asset class, but they’re still chasing asset classes, and buying gold after it’s gone up for three years. Clearing out of stocks after 2008 was not the right thing to do, right, and a lot of people did.

Hal Weitzman: Right. Lubos, your research also suggests that fund performance deteriorates over time. So would investors be better off looking for kind of new or kind of funds that have been around for a couple of years.

Lubos Pastor: Yeah we find that performance deteriorates over a fund’s lifetime for as long as 10 to 12 years. It just gradually goes down on average.

So indeed it is—

Hal Weitzman: Why is that? Is it that again because there’s more competition from younger—

Lubos Pastor: Yeah, it seems that there are really two effects going on. So you start out running a new fund, OK, and in your first couple of years, you’re having a blast because you just . . . you have this new strategy you suggested and the strategy is working.

But then over time, on the one hand, you learn on the job and that’s good for you. On the other hand, though, there are newbies coming in, new kids coming in with new skills, and maybe even emulating your strategy, and that’s pulling you down.

And we find that the net effect of these two effects is actually negative. So funds do worse as they get older. And indeed that implies that going with younger funds—other things equal—is a good strategy.

Hal Weitzman: And younger money managers as well, not just the funds but the actual—?

Lubos Pastor: Well, we looked at it two ways. We looked at younger funds. That’s our main analysis. And we recently added a follow-up at the manager level.

So if you . . . it also makes sense to go with managers with shorter tenure, with fewers years of experience. We didn’t look at the actual age of the manager, but we’ve looked at years of experience.

Hal Weitzman: Really? So inexperience is a good thing in money management?

(panelists laughing)

Lubos Pastor: Holding other things equal. It’s tough to hold other things equal.

Hal Weitzman: Well, unfortunately, on that note, our time is up. My thanks to our panel, Lubor Pastor, Juhani Linnainmaa, and John Rekenthaler.

For more research, analysis, and commentary, visit us online at chicagobooth.edu/cap ideas, and join us again next time for another The Big Question.

Goodbye.

(upbeat piano music)