July 22, 2011 4:59 pm

How fund managers get paid for winning the lottery

Would you be willing to pay a 20 per cent ‘performance fee’ for winning the lottery?

Don’t worry, this is not the government’s latest wheeze for bringing down the deficit – although, following last week’s record Euromillions jackpot of £161m, I fear it may give them ideas.

Lucky winners Christine and Colin Weir have already had to leave their home in Largs to avoid a deluge of begging letters, so the prospect of George Osborne turning up in Ayrshire to claim £32m of their good fortune is perhaps not beyond the realms of imagination.

In fact, it would be quite an effective fiscal policy. According to UK lottery operator Camelot, total ticket sales across all channels reached an all-time high of £5,822m in the year to March 31. So, with 45 per cent of proceeds being paid out in prizes, a 20 per cent performance fee could earn the Treasury £524m – enough to fill in the black hole in the defence budget or reverse spending cuts to national IT projects, the Welsh grant, or the Child Trust Fund. Deserving causes all. Well, some of them, at least.

However, it was actually a hypothetical question put to me this week by Rick Di Mascio, a former pension fund manager who now runs investment evaluation firm Inalytics. He was referring to another multi-billion pound game of chance: investing in equity funds. I say “chance” because he brought me proof that fund managers’ performance is as much down to luck as skill.

Our meeting came about because Rick had read my column of a few weeks’ back, disputing whether fund managers can lay claim to any real ability (Luck goes with skill as cream goes with strawberries, July 9). This in itself was based on an article we ran a couple of months ago, which revealed that only 16 out of 1,188 UK funds had achieved top quartile performance in each of the past three years (Managers still fail to deliver consistently, May 28).

While financial advisers were quick to laud the 16 as geniuses, an economics professor wrote to say that anyone with an elementary grasp of probability would know that a quarter of a quarter of a quarter must, by definition, be top quartile in all three years. That’s 1.5625 per cent – or 18 of 1,188 funds. Ergo, the 16 ‘consistent’ fund managers were as likely to have been lucky as skilful (and, presumably, the missing two were just extremely unlucky or extremely inept).

But Inalytics claims to know which it is. It has built a database of every buy and sell decision made by fund managers at 30 different firms, to determine how good their judgment is. By tracking what happens to the shares after they make these decisions, Inalytics can quantify how often the managers get it right, and how efficiently they run winners and cut losers.

As one might expect, given the large sample, the win-lose ratio tended towards 50:50. Over three years, the average fund manager got it right 49.6 per cent of the time, and the best managers just 53 per cent.

So Inalytics decided to focus on those managers who appeared to get it right more often than not, and took Australian funds as an example. According to its database, between April 30, 2006 and December 31, 2010, 42 out of 62 Australian funds outperformed the benchmark ASX 300 index – enough to justify their charges, one might think. Deserving cases all. Well, not quite.

When their managers’ decisions were studied in detail, it began to look more like luck. Or inadvertent contrarianism. Inalytics found that a high proportion of the positive performance came from stocks that the managers had underweighted. In other words, it was the holdings they didn’t rate and bought less of that produced the biggest returns (and vice versa). Overall, 39 of the 42 managers owed their positive returns to underweights – and, for seven funds, the contributions from the overweights were actually negative.

Why does this matter? According to Di Mascio: “These results show that there is a marked difference between the track record of a manager and their level of skill… This is interesting as many fund managers will charge significant performance fees relative to the index.”

Interesting? Scandalous more like. Just last week, my colleague Alice Ross reported that 91 UK funds are now charging investors up to two per cent a year just for doing their job, plus another 15 to 20 per cent for this inspired performance (Investors warned off funds with performance fees, July 16).

As Di Mascio said to me on Tuesday: “These funds effectively charge a performance fee for winning the lottery. If they base the fee on a track record that depends as much on chance, you are paying for luck as much as skill.”

It seems that in fund management, unlike any other service industry, you don’t get what you pay for. You pay for what you get.

matthew.vincent@ft.com

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