Exploiting Skill

There is skill among mutual fund managers. I tell you how to exploit it.

This is a quick overview of my investigation of Threshold Distortion.

I started with an article that claims that actively managed mutual funds are losers. I analyzed it carefully. I found that the article’s data show quite the opposite. The data prove the existence of skill. It is 3% to 4% (annualized). I have included instructions about how to take advantage of this skill.

These are the relevant articles:

Beware of the Threshold Distortion
Beware of the Threshold Distortion

More on Threshold Distortion
More on Threshold Distortion

Threshold Distortion: Skill and Luck
Threshold Distortion: Skill and Luck

This was my complaint:

There is one trap that I have seen much too often. It is using thresholds in the presence of randomness (noise). It is used in arguing against the existence of investor skill. I say this very bluntly: this method of presentation propagates a lie.

Here is the method:

A person observes the initial price of a stock or mutual fund to see how well it does over a fixed number of years. This can be as short as one year. It is seldom longer than five years. He looks at prices (or total return) once more after a second interval. Then he compares what has happened during the first interval to what happens during the second.

There are three relevant times: the start, the middle time and the end.

For purposes of discussion, let us examine what happens when prices are completely random (after subtracting out the average). Prices at each of the three times can be positive or negative (relative to the average). The typical price is zero (relative to the average).

Let us now introduce a threshold at the middle time and use it for selecting stocks (or mutual funds). We will set the threshold high. Only a few stocks (or mutual funds) will exceed the threshold.

Consider how these stocks (or mutual funds) behave. Typically, they start close to zero, rise high enough to pass the threshold. Typically, they should fall back to a value close to zero. In a few instances, they would have started or ended up significantly higher or lower than zero. But typically, they would have been close to zero. We should see a sharp price increase in the first interval followed by a comparable price decrease in the second.

When stock (or mutual fund) prices are truly random, selecting the best performers during the first interval is the same as selecting which stocks (or mutual funds) are most likely to do the worst in the second interval.

If there were no randomness whatsoever, selecting the best performers during the first interval should be the same as selecting the best performers during the second interval.

What we see is critically dependent upon the degree of randomness when compared to the level of skill (i.e., the noise level as compared to a signal).

The funds did not give it all back. They gave back only a fraction. The measured level of skill among top performing mutual fund managers is 3% to 4% compared to other mutual fund managers. The measured level of skill among top performing mutual fund managers net of fees produces returns that exceed the S&P500 index by 2% to 3%.

The big payoff from skill came during the first five years. With frustrating regularity, I hear people referring to later returns as the payoff from skill. We are told that all that we can get is 0.42% to 0.96% by selecting skilled managers.

The tremendous 3% to 4% advantage has fallen into oblivion, to be consumed by fees.

Let me be harsh. Let me be blunt. I am tired of such nonsense.

We lose our 3% to 4% skill advantage only if we abandon price discipline.

Has anybody considered waiting on a favorable price? Apparently, too many economists can’t imagine such a thing. They would have us pay full price at year 5 for the hottest fund of the last 5 years. Or, at least, that is how they conduct their studies. If that is the limit of one’s investment sophistication, perhaps he really should buy index funds on a mechanical basis. It is far better than paying top dollar for today’s hottest hand.

Here is my procedure:

Price discipline is essential.

1) Identify the top diversified mutual funds over the past 5 years. You don’t need to identify 30, but you do want to identify more than one or two.
2) Eliminate funds that are no longer suitable. Typical reasons would include changes of management, style drift and/or increased fees.
3) Eliminate funds that you do not like for other reasons such as too much volatility or self-serving management. Retirees are likely to focus on dividends.
4) Follow 5 to 10 of them carefully.
5) Identify before and after prices of these superior funds. Find out how far your fund would have to fall to bring its total return down to the level of the S&P500 index.
6) Set aside a time interval between 2-5 years to purchase one or two of these mutual funds. Not all of them will return to favorable prices. Some of them will. Depending upon market conditions, you may be able to pick one up below the price that you have calculated (i.e., equal to what it would have been if it had matched the S&P500 index from the start).

I have quantified the degree of randomness among actively managed diversified mutual funds. The skill level is 4%. The randomness in the (original 5-year) selection period is 4% (on the upside). This applies individually to all the selected funds.

This is very fortunate. It means that the prices of many of the best funds will return momentarily to the price of the average fund within the next 5 years. This verifies that you will be able to pick up some bargains.

Have fun.

John Walter Russell
July 6, 2005