The Fund Industry’s Dirty Little Secret - The Illusion of Skill
Posted by: Brian Dennehy
Something is badly wrong with the investment industry. It was highlighted in the first half of the last century, if not also in the century before. But what is wrong?
Investors have been being screwed for a long time
(excuse the vernacular – but this needs stating clearly, so no one is left in any doubt). The evidence of problems wasn’t ignored by everyone. It spurred on the development of index tracking funds, to the extent that passive investing is now a dangerous bubble phenomenon (see Boom Bubble Bust Part II: ETF Mania
This means investors now have the guaranteed mediocrity of passives/index trackers, or the high probability of mediocrity, at best, from actively managed funds – or at least 92% of them, as our own research highlights.
The result is that the investment fund industry is dominated by two highly polarised camps – neither of whom serve investors well.
This week I want to better understand the problem, with a little help from one of the world’s outstanding brains.
Confidence in, crap out [sorry]
Fund managers and other investment pros confidently believe they are making sensible, educated judgements – but the outcomes show that sensible and educated judgements are simply not good enough, and that their confidence is mis-placed.
Confidence in our own judgments is a vital part of being human. But our judgement, and the way our brain works, is also notoriously imperfect.
Daniel Kahneman (Noble-prize winning economist and professor of psychology) tells us he often interacts with “professionals who exercise their judgment with evident confidence, sometimes priding themselves on the power of their intuition” [my bold].
What about professionals in the investment industry? Kahneman does not pull his punches on fund managers:
“Funds are run by highly experienced and hard-working professionals who buy and sell stocks to achieve the best possible results for their clients.
Nevertheless, the evidence from more than 50 years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice.”
There is little evidence that investment professionals exercise skill, because if they did there would be evidence of consistent outperformance of markets – there isn’t. FundExpert has highlighted this frequently, based on our own detailed research – it is set out in my book in detail – and this confirms other research which stretches back decades, as DK mentioned. He continues:
"The funds that were successful in any given year were mostly lucky… this is true for nearly all stock pickers, whether they know it or not — and most do not."
DK was invited to speak to a firm of investment advisers who worked with very wealthy clients. In advance, at his request, he was given data on the results achieved by 25 of their advisers for eight consecutive years.
It was a simple matter to rank the advisers by their performance and discover:
Did the same advisers consistently achieve better returns for their clients year after year?
Did some advisers consistently display more skill than others?
Though he probably had a feeling in advance of the answers, he was still surprised by the results:
“The results resembled what you would expect from a dice-rolling contest”
There was no evidence of any skill. No one in the firm seemed to be aware of the nature of the investing environment nor what it takes to succeed. DK reflected:
“The advisers felt they were competent professionals performing a task that was difficult but not impossible, and their superiors agreed”
Unfortunately, the Illusion of Skill is deeply ingrained in the culture of the investment industry.
Facts that challenge the industry's basic assumptions, of hard work and skill and competence, are simply ignored. DK says this denial is “particularly true of statistical studies” which illustrate they are achieving mediocrity, at best.
“Their personal experience of exercising careful professional judgment on complex problems was far more compelling to them than an obscure statistical result.”
As an investor it is difficult to know how to sidestep this deep-seated problem.
How do you distinguish the justified confidence of experts from the sincere overconfidence of investment professionals who do not know they are out of their depth? Over to DK:
“You should not take assertive and confident people at their own evaluation unless you have independent reason to believe that they know what they are talking about.
Unfortunately, this advice is difficult to follow: overconfident professionals sincerely believe they have expertise, act as experts and look like experts.
You will have to struggle to remind yourself that they may be in the grip of an illusion.”.
I believe the only antidote is a focus on the facts – the meaningful and objective facts. Facts whose validity and relevance you can test over a long period. No facts will provide a guarantee of success – if that was possible the huge brains and mega computers engaged in the investment industry would have discovered that Holy Grail already.
Knowing those meaningful facts will simply move the odds of your success heavily in your favour, providing that you apply them within a clear investment plan.
Next week I will identify those facts.