How to Exploit Skill

Here is a short explanation of how to exploit skill among mutual fund managers. See Exploiting Skill.
Exploiting Skill

Your first task is to identify a large number of mutual funds that are similar. Our data were limited to diversified funds. It is best for you to limit this to funds that are suitable to you as an individual. They should have similar amounts of volatility.

Next, determine which funds have done the very best after 5 years. We looked at the top 30. To do this, you determine how much a specified investment (such as $10000) would have grown, net of all fees.

Over the next 2-5 years, compare the prices of your top funds with the average price of all of the funds. That is, you determine the current value of each fund assuming a fixed original investment (in this case $10000). You take the average of all of the funds as a group. You compare the current value of each of the top funds with this average.

Whenever the current value of one of your top funds dips back down to that of the average value (of all of the funds), buy it provided that it is still suitable. As a practical matter, it is unlikely that your top funds will dip this far, but several will come close.

This is why it works:

The first step eliminates mutual fund managers who possess no skill. [It also eliminates many who do have skill.] It also eliminates managers who have a talent for losing money.

Here is an important point: it is possible for a fund that is much more volatile than the others to give you a false indication. This is why the funds should be similar and why they should all be suitable for you.

All of the funds selected are lucky. Their returns come from both skill and luck. To be among the very best performers, they could not have been unlucky. To be among the very best, they had to be almost as lucky as it is possible for them to be lucky. The price at year 5 adds to the fund manager’s skill all of the upside that he will ever get from luck alone. Year 5 is the worst time to buy these funds.

Prices will fluctuate both up and down about this level of skill. You want to buy funds when they fluctuate down. When we looked at the numbers, we found that skill and luck were approximately equal.

This process not only identifies funds with skilled managers, it also identifies a fair price. This is key. The fair prices are roughly midway between the momentary values at year 5 and the value of the average fund (as a percentage). When we buy these funds at a price close to that of the average fund, we get a bargain.

Have fun.

John Walter Russell
July 7, 2005