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Letters to the Editor
Luck versus Skill: Round Three

August 19, 2008

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The following four letters 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.  Professor Howard’s response is shown here.

Dear Editor,

Unfortunately, Dr. Howard’s study features as much bias as Dr. Wermers’, if not more so. The thing that makes this problem so interesting is that they can both be right, and both provide so little guidance for investors.

Dr. Howard’s largest bias is that he owns a company based solely on the concept that he can identify superior fund managers in terms of performance. If no such superiority exists, his company has been selling a worthless service. Like the pig and the chicken at breakfast-time, Dr. Wermers may be involved, but Dr. Howard is committed!

Some specific points of view from an investor’s standpoint:

  1. Newer funds often show superior performance as they are forced to contain less of the investment universe than larger funds who eventually they bloat up. I could buy Dr. Howard’s argument if he recommended only newer, pin-point style funds, especially when they are usually formed jumping on a trend. I could make the argument that his study is totally dependent on new fund bias, yet the average investor shares in none of this as advisor’s may not even be aware of the new fund until it has achieved a critical mass from in-house money.
  2. As funds get larger, you would expect that they would show smaller standard deviations reducing risk for investors. This is caused by both the larger universe of stocks getting closer to a market index and the inherent conservatism we see among fund managers as they grow larger.
  3. The most compelling point is that the increasing universe of mutual funds combined with the much larger fund pools they control have arbitraged away any opportunity for superior long-term active management performance. There are a limited number of equities, and with all funds using similar screening tools, as soon as one fund sees an opportunity, they all see it, and any superior returns are quickly arbitraged away.
  4. Lastly, even if Dr. Howard is right and there is a long-term improvement in active managers performance (which I don’t buy, but there certainly has been an improvement in investment tools), why are fund alpha returns declining overall? It is because large funds are becoming a larger share of the industry. We all know that a very small group of funds attract the vast proportion of new assets.

I love these debates. I figure the professors can support any side of the argument. I have to stand there when a large client has seen-below market returns from a fund my firm has recommended. As such, it is index ETFs for us with extensive allocation of separately managed, tax-advantaged accounts.

Cheers, and keep up the good work.

Bob Ellis
Senior Vice President, Wealth Management
Celent
New York, NY


Dear Editor,

I have three observations to Dr. Howard’s letter “Letter to the Editor – Luck versus Skill in Active Mutual Funds”:

  1. He observes that it is the newer or shorter term manager’s results that increase the alpha in recent years. Longer time periods cause performance to deteriorate. If “newer” managers are more “skillful”, what causes them to lose their skill when they gain more experience? This logic definitely trends to the idea that any added alpha is indeed luck rather than skill. How many trades or professions can you think of where more experience equals less skill? This logic is faulty on its face.
  2. If I am going to attempt to pick these “skillful” managers with short histories, how am I to distinguish between the “skillful” and the “lucky”? With essentially no history, I have no way of determining a manager’s skill in advance of his longer history and consequent reduced performance that comes with more time on the job.
  3. Since time on the job equals reduced performance, I am forced to choose an optimal time to fire this “skillful” manager before his “skill” diminishes and find another “skillful” newbie to replace this worn out old manager who has more than five years experience.

The observations in Dr. Howard’s letter do me absolutely no good in assisting me to select “skillful” outperforming alpha adding managers over what I can achieve with passive asset class investing.

Charles Stanley
Capital Financial Advisors, LLC
La Jolla, CA


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