Are top-performing investors good? Or just lucky?
It can be hard to tell the difference. When Nobel laureate Gene Fama studied outperforming mutual fund managers, he found that most of them were just taking big risks. Their portfolios returned more than the market, but their portfolios were also more volatile than the market.
When you measure return and divide it by volatility, it’s a lot harder to stand out. And it’s hard to measure risk. Volatility is just one measure. Concentration is another. If you bet your entire stake on one horse, you’re taking a big risk—even if that bet works out. There are simply too many things that can go wrong—accounting fraud (Enron), marketing errors (Coke), CEOs behaving badly (HP), running out of capital (Bear Stearns, Lehman, Fannie Mae). The list goes on and on.
So some managers go outside of their investment universe to find low-risk outperforming investments. But that’s cheating. A bond fund shouldn’t juice its returns by buying utility stocks, even if the analyst “knows” that utilities are likely to go up in price. If you look closely, you find that a lot of bond funds poach by buying equities, and vice versa. They disclose it on some back page in their prospectus supplement, to make it legal. But just because it’s legal doesn’t make it right.
Not everyone cheats, though. We do observe expertise in other professions: lawyers, surgeons, hockey players. It’s not a stretch to think that professional investors can show skill as well. Only, finding that skill is hard. Returns only tell part of the story. Risk-adjusted returns are the best measure of real performance. We know what returns are. Understanding risk is a lot more difficult.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!