Luck goes with skill as cream goes with strawberries

How much of a fund manager’s – or a tennis player’s – performance is down to chance?

Skill or luck? How much of a fund manager’s investment performance can be attributed to one or the other?

When not wondering how much managers actually pay to have their funds promoted on an online platform and how much it really costs to buy and hold their funds, this is the third question that nags away at the back of my mind.

Skill must play a major part in achieving consistent investment returns, mustn’t it? Why else would fund managers be in the job? It’s like sport. Tennis players with the skill to achieve a consistent first-serve percentage – and consistent backhand returns – always win more sets than those who lack it. If park players could return 70 per cent of Rafa Nadal’s first serves, they’d all be in next week’s qualifying tournament for Wimbledon. Similarly, if private investors could run portfolios generating double-digit returns, they would. They don’t, so presumably they can’t.

According to research out this week from Schroders, 1.5m private investors have all their shares invested in a single company. It’s too difficult to pick more. These one-stock wonders are not even that wonderful – in the survey, almost a third admitted to a strategy not dissimilar to that of a plucky British No 4 on an outside court against a top seed: having been on a long losing streak, they are just holding on and waiting for a lucky bounce. But luck doesn’t come into it, remember. It’s all skill.

Financial advisers seem certain of this. Commenting on the one-stock wonders, Darius McDermott of Chelsea Financial Services suggested they leave it to the professionals: “Investing in a unit trust managed by an experienced active fund manager with a good track record should ensure the portfolio is regularly rebalanced, allowing the investor to take profits.”

He has a point. If a manager has “a good track record”, that manager has a repeatable skill – and the more repetition, the better.

If you can come out ahead in two consecutive years, you set yourself apart. It was notable that in this week’s 2011 Thomson Reuters Extel Survey, JP Morgan Asset Management was named Leading Pan-European Fund Management Firm for a second consecutive year. Winning twice in a row is what separates the McEnroes and Beckers from one-win wonders like the Stichs and Ivanisevics.

If you can succeed in three consecutive years, you must be something special. It struck me as telling, therefore, that last month’s Thames River Multi Capital consistency ratio, which measures the proportion of funds that have produced top quartile returns in each of the past three years, found that only 16 out of 1,188 had achieved the feat. How skilled must they be? They are the Samprases and Federers of fund management. “When there has been a series of very different markets, anyone who can outperform in all those scenarios must be very good indeed,” says McDermott.

Very good. Or very lucky? There is another way of looking at it, which has been suggested to me by an economics professor. We know that just 16 out of 1,188 funds managed top quartile returns in three consecutive years. That’s 1.35 per cent. However, if success were entirely due to skill, the same 25 per cent of funds would be in the top quartile every year. If, instead, it were entirely due to chance, then a quarter of this year’s top 25 per cent of funds would have been in the top quartile last year, and a quarter of those in the year before that. That would mean 25 per cent were one-year top performers, 6.25 per cent were two-year champions, and 1.5625 per cent were three-time winners. Fund managers actually do worse than this.

Or think about it this way: if it were to rain heavily between June 20 and July 3 and all Wimbledon tennis matches had to be decided by the toss of a coin, even our plucky British No 4 would have the same chance as Nadal – 1.5625 per cent again – of getting to the final. If Andy Murray’s ankle doesn’t hold up, it could be our only chance.

What does that say about our chances of picking a consistent fund? In search of reassurance, I spoke to one of the three-times fund champions this week: Mark Slater, whose MFM Slater Growth Fund has returned 47.8 per cent, 69.75 per cent and -23.2 per cent (enough to be top quartile) in each of the three discreet years to the end of April 2011. His secret? A well-honed technique and lots of practice.

He screens the UK stock market for companies with above-average earnings growth forecasts, a low price-to-earnings growth (PEG) ratio, and strong cash flow – and then overlays the price-earnings (p/e) ratio to screen out expensive stocks. From a shortlist of 100-150 companies, he tests the growth dynamics by looking for an increase in market share, rising margins, good return on capital and low capital expenditure.

Slater says this helps to generate a strong “tail-wind”. Flagging investors – and British No 4s who are break-point down on second serve – could certainly do with one.

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