One of the greatest difficulties when choosing an asset manager to look after your hard-earned cash, is determining whether their performance is due to luck or skill. Over short periods of time this distinction is nearly impossible to tease apart. If a group of people with no investment experience were to create a portfolio of stocks at random, some of the portfolios would outperform the market while others would underperform. Clearly the outperformers did not beat the market using skill. And yet, due to human nature, the outperformers would confidently state that they were talented, while the underperformers would grumble about their misfortune.
In sport, unlike in investing, one can quickly separate the amateurs from the pros. If I were to play a round of golf with Tiger Woods, no amount of luck could make up for my lack of golfing prowess. Similarly, if I spent five minutes on the pitch with the Springboks, I would be sent to the emergency room after one tackle. The difficulty for investors and financial advisers is determining which asset managers can provide market-beating returns over the long term.
Roger Federer is considered one of, if not, the greatest tennis players of all time. He has won a record eight Wimbledon titles and his career prize money sits at over $120m. Most people when asked to guess Federer’s points win percentage (the percentage of points won divided by total points played) think the number will be close to 70% and yet, the actual answer is only 54.2%. Said differently, one of the all-time tennis greats wins just over 50% of the points he plays. This small margin of victory, when executed consistently and over long periods of time, has delivered Federer 20 Grand Slam titles. Similarly, when asset managers get more than 50% of their calls right, this will produce alpha for their clients.
Continuing with the tennis analogy, it is not only about how many points you win but more importantly, which points you win. Federer played Novak Djokovic at the 2019 Wimbledon Final. The thrilling match reached five sets but ultimately Djokovic prevailed. When looking at the statistics though, Federer comes out tops. He won a total of 218 out of 422 points (51.6%) but lost the match because Djokovic won the more important points. Out of the three tiebreaks played that day, Djokovic won all three, including the fifth set tiebreak which determined the Wimbledon championship. Asset managers need to size their positions accordingly, so that winning investments deliver out sized performance.
For investors and financial advisers, selecting asset management firms can be challenging. In an attempt to select managers with skill rather than luck, choose firms where you understand what drives their alpha and why their edge is sustainable over time.