Skilled?

June 27, 2025

You may hear in financial media from time to time about a star fund manager who has “outperformed” the market over the last so many years. It always attracts attention, and new inflows of money rush to the manager’s strategy. To claim outperformance, a manager’s returns must be weighed in context with the level of market risk that was taken. You may recall in a previous newsletter (here) I explain that a Ferrari beating a Honda Accord didn’t outperform, it just did what it was supposed to do. But in the instance outperformance appears legitimate, for the risk taken, we should always ask if the manager had skill, or if it was just luck.

Assessing evidence of manager skill relies on statistical methods. Measured outperformance, called Alpha, varies from year to year. Based on this annual variability and the number of years, and assuming a normal probability distribution, we can calculate a t-statistic and weigh it against a critical value for a level of significance. Blah, blah, blah. What the heck am I saying? Essentially, we are attempting to quantify the following question, “How likely is it this ‘outperformance’ happened by random chance alone?” If random chance is not very likely, then you probably found evidence of skill, otherwise you are looking at nothing more than luck. In other words, the result must be so remarkable, statistically speaking, that you can safely rule out luck.

The distinction between skill and luck is important because it informs what might happen in the future. There are currently about 7500 or so actively managed funds, just in the USA alone. By random draw, some of these funds will beat their benchmark by accident (dumb luck). Utilizing our trusty rear-view mirror, and with help from our friends in financial media, we will notice these past “winners” and we might then make some unfortunate assumptions about the future.

Here’s a crude example to illustrate this. Say we have a room of 1000 people, each with one quarter. We ask them to flip their quarter, and as long as it comes up heads, they get to keep flipping. Those who flip a dreaded tails must go stand by the wall of shame. After a few rounds, we’ll have a small group of heroes remaining who have flipped heads eight times in a row! This exclusive group of expert coin flippers will be crowned “Flipping Gurus!” and they will be interviewed frequently to tell their tale of coin flipping expertise. OK, timeout. We bring the 1000 people back, and they start flipping again. We make it a few rounds, our wall of shame is full, and we are left with another exclusive group of heroes. Mr. Chance is there again (truly amazing!), but Mr. Luck, Mr. Rando, and Ms. Fluke are all gone. Mr. Chance and his new pals go on another publicity tour. In subsequent rounds the aforementioned heroes never make it back to hero status, and are just replaced by different heroes, then different heroes again. The random nature of luck created a veneer of skill.

In the face of such randomness, many firms cling to industry practice and dangle the idea that they can select fund managers with “superior” returns, which makes them appear to have a sophisticated or unique methodology. This is the pretext for justifying higher fees. With luck masquerading as skill, like a mirage, what you perceive as opportunity, and what you have in reality, are two very different things.

One Day In July recognizes utilizing actively managed funds and attempting to find the “best” fund managers, is a statistically losing game. No one can do this well with any consistency, but they will certainly charge you more to try. Our skill is understanding this, acknowledging it, and not falling prey to the ever-present instinct to ignore this sobering reality. This takes real humility and discipline. It is this humility and discipline that creates sensible investment plans and a more likely path to better returns.

- John Bass