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The investment management business is all about skill, but skill is elusive. Indeed, some have suggested that skill is not just elusive but illusory: there is no such thing as skill, or no reliable way of identifying it. This suggestion is a key component of the efficient market view of the world (EMV), which has posed a major challenge to active investment management.

The EMV no longer dominates academic finance. We now have a host of alternative theories, such as behavioral finance, the adaptive market hypothesis, complex adaptive systems, chaos theory, catastrophe theory, and fractal geometry. Thus it may seem that the EMV no longer poses a threat to active investment management.

Not so. The EMV is a combination of insights and myths. The insights do present a challenge to active management, but that challenge can be met. However, meeting that challenge forces us to think more clearly about what skill really is. If you have the wrong ideas about skill, the insights of the EMV will force you to conclude that it doesn’t exist.

1. Scarcity and Variety

Before confronting the EMV head on, let’s note three preliminary points about skill. The first and most obvious point is that skill is rare. There are lots of competent money managers, but competence is not the same as the kind of talent that gives you a competitive edge. Furthermore, skill is rare throughout the investment world. Hedge fund enthusiasts talk about a brain drain in which the most talented managers have left the long-only world to seek the greater freedom (and higher fees) available in the hedge fund world. However, genuine skill is as rare in the hedge fund world as it is elsewhere in the investment business. Hedge fund managers operate with fewer investment constraints than long-only managers. This is a great advantage for the skilled manager, but gives the less skilled manager more ways of getting into trouble. The transition from long-only investing to hedge fund investing is not easy. Many hedge fund managers are not as talented as they claim to be, and there are many talented long-only managers who have their own reasons for not joining the rush into hedge funds. The barriers to entry in the hedge fund business are seductively low; the barriers to success are formidably high.

The second point is that we don’t know exactly how rare skill is, since there are no generally agreed-upon criteria for determining whether a manager is skilled. There are no “reliable techniques” for separating the skilled from the unskilled. It’s easy to count the number of managers who meet specified performance criteria, but, as we shall see in more detail later on, the linkage between skill and performance is loose. This means, by the way, that skill is not the same thing as alpha, since alpha can be measured but skill cannot. Once you’ve calculated the alpha from a series of historical returns, the question is: Does this alpha reflect real skill, or did the manager just happen to be in the right place at the right time? Calculating the t-statistic of the alpha does not conclusively settle the question: smart and well-informed people may disagree about the level of skill that lies behind a good record. Pronouncing a manager to be skilled is a value judgment, like pronouncing a stock to be attractively priced. So the ability to identify skill is itself a form of investment skill. When you’re hunting for skilled investors, it takes one to know one.

The third point is that skill is multi-faceted: it is not some monolithic quality that takes the same form in every case. For example, skill involves a combination of “book smarts,” “street smarts,” and “emotional intelligence,” but the proportions vary considerably from manager to manager. And there are wide variations in risk attitudes: some skilled managers are very risk averse, quick to exit losing positions, while others are more loss-tolerant, and may even double down on losing positions. The variations of skill are endless. Buffett’s skill is utterly different from George Soros’, just as Picasso’s genius is utterly different from Rembrandt’s.

2. The Two Main Insights

The EMV’s critique of active management is based on two insights: There Are No Free Lunches and Nobody Knows Anything. The first point reminds us that return requires risk: there are no opportunities for risk-free arbitrage, no $100 bills sitting on the sidewalk waiting to be picked up. In the language of the EMV, there are no “market inefficiencies,” precisely because so many people are looking for them. The EMV is based on a giant negative feedback loop, or a Zen riddle: we all try so hard that we are bound to fail. (Here the Zen master would insert various inscrutable remarks about the futility of all human striving.)

It is unrealistic to insist dogmatically that there are no market inefficiencies. There may be a few “pricing anomalies” lying around. However, if there are any market inefficiencies then they are few and far between, not abundant enough to support the multi-trillion dollar business of active investment management. In particular, the hedge fund business is not designed to exploit market inefficiencies. There are many hedge fund strategies that call themselves “arbitrage”—merger arbitrage, convertible arbitrage, fixed income arbitrage, capital structure arbitrage, and so forth—but all these strategies involve risk. This is true even in the current environment. Investor fear is creating some exceptional opportunities, but they are not risk-free. It takes skill to catch a falling knife.

The second insight, Nobody Knows Anything, reminds us that Wall Street is just like Hollywood. In each place, people in the business know a lot, but they don’t know what they really want to know. In Hollywood, nobody can predict whether a movie will be a smash or a bomb. On Wall Street, nobody can predict stock prices or manager performance.

The academic literature tells us that the future is not a simple extrapolation of the past. But even people who make fun of the academic literature accept the fact of unpredictability. We make jokes about generals who fight the last war and people who drive by looking in the rear-view mirror. Money managers who pay little attention to the EMV will cheerfully confess, “Hey, if I could predict the future do you think I’d be working for a living?”

The two insights of the EMV tell us something about manager skill. If skill required exploiting market inefficiencies and/or predicting the future, then there would be no such thing as skill. But skill does not require inefficiencies: it requires the ability to make intelligent judgments about risk and reward. Similarly, skill does not require predicting the future: it requires the ability to form reasonable expectations and to respond intelligently when those expectations are confounded. As George Soros observed, the question is not whether you’re right or wrong—it’s how much you make when you’re right and how much you lose when you’re wrong.

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