Zero Sum game
Investing is a zero sum game; this means that the sum of investor’s gains and losses is zero from the market return. Over the past 40 years (until 31/03/2020), the market has returned on average 11.26% per annum as measured by the MSCI World Index (volatility of 17.39%).1 If the market return is 11.26%, the average market return for all investors is also 11.26%. Passive investors will each have returned 11.26% minus their costs (c0.5%) and received 10.76% per annum had they stayed the course.
Active investors too, will have on average returned 11.26% per annum minus their costs. However, their costs are likely to have been far higher at c2% and so on average they will have returned 9.26% per annum. In reality, some will have received far higher returns and some far lower.
How do you know if those outperforming the average are skilful or just lucky?
In a normal distribution of returns, 95% of expected returns fall within two standard errors of the mean. Therefore, in order to demonstrate that outperformance is due to skill with a 95% confidence, the average return needs to fall outside of two standard errors.
Standard error is related to both volatility (standard deviation of sample) and time (number of annual periods, N)
So how many years of performance are required to prove skill?
If an active manager wanted to prove that they could beat the market by 2% (i.e to cover their costs), they would need to return this on average for c300 years.
Obviously, this is well outside the career lifetime of a fund manager.
How large does outperformance need to be in order to prove skill?
If we look at it another way, the longest-serving fund manager has clocked up c35 years in charge.2 With 35 years’ service, you would need to outperform the market by 5.88% (two standard errors) per annum in order to prove skill. That is an average annual return of 17.14% (before costs)! To our knowledge, this has not been delivered.
Actual returns by active fund managers
Andrew Green ran the GAM Global Diversified fund for nearly 34 years (09/01/1984 – 31/12/2017).2 Over this time, he returned on average 12.39% a year and the MSCI World index returned 8.52% per annum with a volatility of 15.26%.1 This puts the range of likely returns (2 Standard Errors, 95% confidence) at 3.29% to 13.75%. This means, the return generated by Andrew Green was well within those likely to occur.
Furthermore, in 14 of those 33 calendar years, the GAM Global Diversified fund underperformed MSCI World.1 It cannot be proven with any degree of certainty that the overall outperformance generated by Andrew Green was down to skill.
Likewise, once referred to as a ‘star’ investment manager, Neil Woodford’s past returns fall well within the range of expected returns. If we consider the time he spent at Invesco, this could be attributed to good luck. Similarly, the 5 years in which he ran his own funds, and made himself millions3 and lost his investors up to 42% of their savings,4 could be attributed to bad luck. Take a look back at Matt Kiddle’s article: Fallen Stars.
Here at bdb, we are evidence-based investors. The evidence not only shows us that on average, active funds underperform, but also that we cannot prove the existence of skill in active fund managers that may have had a spell of good returns. We place our trust in science of Nobel Prize winners rather than the ‘convictions’ of an active fund manager.