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The following is in response to four letters that were received in response to Professor Tom Howard’s article last week, which was in response to our article the prior week, Luck versus Skill in Active Mutual Funds.
Response to:
Luck versus Skill Letters
C. Thomas Howard, PhD
Professor, Reiman School of Finance
University of Denver
and
CEO and Director of Research
AthenaInvest, Inc.
August 19, 2008
Bob Huebscher’s August 5 article about the Barras, Scaillet, and Wermers (BSW) paper and the ensuing responses by Ron Surz, Russ Wermers, myself and others is generating a good discussion around luck versus skill among active equity mutual fund managers. In last week’s response, I presented evidence that manager skill increased over the 1980 to 2008 time period rather than decreased, as BSW conclude. Below I comment on the four new letters generated as a result of my response.
Investing in Active Managers Makes Sense
My data shows that average alpha is increasing over time and is now positive. This puts a serious crimp in the argument that an advisor can rationally index client portfolios and still be operating in their best interests. I estimate that the current average active U.S. equity fund outperforms the S&P 500 by about 100bp. Indexing is now a second best alternative.
Emphasis on Portfolio Characteristics rather than on Fund Strategy
Several respondents claim my results are due to managers simply riding trends. My response is “so what.” Isn’t that what we pay managers to do - identify market trends and ride them as long as it makes sense? Unless the advisor or investor is good at identifying such trends ahead of time, and the evidence is not supportive of this proposition, a manager should be allowed to do their job.
What many advisors do instead is Monday morning quarterbacking. They say, for example, a manager did well because the fund is invested in small-cap stocks and these stocks did well. Then they turn around and force the manager, who just happened to be invested in small-cap stocks because of the strategy being pursued, to be a small-cap manager going forward. Then they are upset that the manger performs poorly as a small-cap manager. We create our own problems! The focus should be on manager strategy and not on portfolio characteristics. The relentless pursuit of a well crafted strategy is the key to superior performance, while portfolio characteristics are a byproduct that should be ignored.
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