The following letter is in response to a letter to the Editor published last week. 

Dougal Williams and I have been debating the merits of active vs. passive investing. Mr. Williams seems open to the possibility that skilled managers exist but since he cannot identify them in advance, he believes active investors must live in a Fantasy Land. In this article, I explain what we have done to find skilled investors and provide links to data showing the effort has been worthwhile.

The Search for Alpha

As surprising as this may sound, very few people in the investment industry have a track record they can call their own. Funds have track records, but managers do not. Without knowing a manager’s track record, how does any advisor find skilled managers to put to work for their clients?

When I realized this, it occurred to me that if we knew the track records of all the managers and their analysts we could do a better job of identifying skilled investors than any other firm. We started Marketocracy to let managers, analysts, and everyone else establish their own track record so we could use the data to assemble the best portfolio management team in the industry. We do this through a website that enables anyone to manage a model portfolio that is priced each day as if it were a mutual fund.

Since we started, more than 100,000 people have set up a model portfolio, and there are now over 30,000 whose track records are more than 5 years old. For each investor, we can drill down into their track record to analyze returns stock-by-stock, and even trade-by-trade. I would like to share some of the lessons we’ve learned from analyzing this data about how to identify and harness investment skill.

Lessons from Coin Flipping

But first, let’s revisit the coin-flipping analogy I used in my first letter. In this analogy, 42,000 people in a stadium are each given one of three types of coins - gold, silver, or bronze. The gold coins are weighted to come up heads 60% of the time, the silver coins 50%, and the bronze coins only 40%. All the coins are painted green so you cannot tell what kind of coin anyone has. After each coin-flip, those who throw tails are asked to leave the stadium. After the 10th coin-flip, we expect there will be 100 people left who each threw heads 10 times in a row: 85 of them will have gold coins, 14 will have silver coins and 1 will have a bronze coin. 

In the next 10 coin-flips the entire group of 42,000 is expected to average 5 heads. But among the 100 who previously threw 10 consecutive heads, the expected average is 5.84.  Based on their track record, these 100 can be expected to outperform everyone, even though these 100 include 15 who don’t have gold coins, and none of these 100 is expected to repeat their performance by throwing 10 heads in a row again. 

When it comes to investing, we could never be as confident about beating the market. Nevertheless this thought experiment has three lessons for us.

First, we are not looking for the one person with the best track record. We are looking for a group.

Second, we don’t have to be right about every manager we select for the group. Randomness will ensure that some lucky people appear skilled. We have to set our standards high enough so we can be confident that most of the lucky ones wash out, leaving us with a group that is largely made up of the skilled.

Third, in order to outperform an index fund, the group as a whole has to do better than the average investor, but none of the managers has to repeat their stellar returns.

Back to Investing

When it comes to investors, throwing heads is analogous to generating alpha. In concept, an investor has a universe of stocks from which to select a portfolio. If an investor’s portfolio delivers a higher return than a portfolio consisting of the entire universe of stocks, then the excess return (alpha) can be attributed to the investor’s skill. Investors who don’t deliver alpha can be excluded from further consideration. As in the coin-flipping analogy, these people can leave the stadium.
 

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