The Evidence-Based Investor

Tag Archive: luck

1. Luck pretending to be skill: self-attribution bias in active management

   October 26, 2023 6:47 pm Comments Off on Luck pretending to be skill: self-attribution bias in active management

    

    

   Self-attribution bias is the tendency to attribute success to one’s own skills and abilities while attributing failures to external factors like luck or circumstances. We’re all guilty of it, and a new study shows that it’s rife in active fund management.

    

   Think back to your time at school or university. The chances are, like most of us, some of your exam results were better than others. Now try to recall what you might have said — to yourself and to other people — in both of those instances.

   When students score top marks in an exam, they tend to put it down to their own intelligence or hard work. When they mess up, they might blame the teacher for not explaining the course material better, or the exam board for setting such difficult questions.

   This is a classic example of what behavioural psychologists call self-attribution bias. The term refers to the way we tend to attribute positive outcomes to our own abilities or efforts, while attributing negative outcomes to factors beyond our control.

   It happens in all walks of life. A CEO, for example, will often attribute good financial results to positive changes they’ve introduced, and poor results to, say, the economic climate. Similarly, a football manager might tell himself that victories are down to his tactical nous, while blaming defeats on poor refereeing or plain bad luck.

   Studies have shown how the same thing happens in investing. When our returns are good we like to congratulate ourselves for making astute decisions; when they’re poor, we might blame our financial adviser, or the newspaper columnist whose tips we were acting on.

    

   Pros are susceptible too

   But it’s not just ordinary investors who display self-attribution bias. Financial professionals are guilty of it too. Now a new study, entitled Heads I Win, Tails It’s Chance, by Meng Wang from Georgia State University, shows just how prevalent the bias is among active fund managers and how it negatively impacts their performance.

   Wang used artificial intelligence software to examine the statements made by US fund managers in official shareholder reports called N-CSR filings that they are required to file with the regulator, the SEC. In these documents, managers typically explain the factors that have either contributed to, or detracted from, their investment performance.

   Wang divided these statements into two — those that linked performance to internal factors such as skilful stock selection, and those that attributed outcomes to external factors such as the economic environment or prevailing conditions in specific sectors. 

   To evaluate the extent to which each manager displayed self-attribution bias,  he created a measure called the self-attribution score (SAS), ranging from -1 to 1. The higher the SAS score, the more likely the fund manager was to  credit themselves for good outcomes and blame external factors for bad ones. 

   The data set  he used included 15,434 shareholder reports associated with 1,969 unique funds between 2006 and 2018.

    

   What the study found

   On average, Meng Wang found, 41% of the factors attributed to performance contributors were external, while 59% were internal. Conversely, 83% of the factors attributed to performance detractors were external, and 17% were internal. 

   Fund managers were, on average, 40.6% more likely to attribute performance contributors to internal factors than performance detractors.

   In other words, the findings suggest that fund managers tend to internalise successes, attributing them to skill, and externalise failures, attributing them to bad luck.

   But more interesting still is the finding that managers who displayed a stronger self-attribution bias tended to engage in more trading in the subsequent reporting period. Studies have shown that fund managers who trade more frequently are often overconfident and inclined to take excessive risks. These traits, in turn, are usually associated with inferior investment performance.

   Another finding of note is that although the funds Wang looked at exhibited a higher self-attribution bias after periods of strong performance, biased attribution only influenced fund flows when funds performed poorly. To put it another way, investors ignored managers’ self-attribution bias when the fund performed well, thereby exhibiting self-attribution bias themselves in their choice of funds.

    

   Lessons for investors

   It’s already well documented that behavioural biases can be very detrimental to investment returns. It’s often suggested, however, that fund managers and other investment professionals are somehow immune to these biases, or at least less likely to succumb to them than the rest of us. However this latest study is one of many which show that professionals are affected as well.

   More worrying still for those investors who use actively managed funds is that fund managers who exhibit self-attribution bias are also more likely to be overconfident and to engage in excessive risk-taking. There have certainly many instances of “star” managers whose performance flopped as a result of taking on too much risk.

   Investors should stay on their guard against their own irrational tendencies. They should avoid acting on their emotions or following the herd. They should also be mindful of their own limitations and pay more attention to long-term trends than to recent events. 

   But they should also be wary of the behavioural biases of financial professionals acting on their behalf, including financial advisers and, especially, fund managers.

   Remember, the best way to avoid any negative impact from behavioural biases is to use index funds — or other systematic, rules-based funds — that take human behaviour out of the decision-making process altogether.

    

   ABOUT THE AUTHOR

   ROBIN POWELL is the editor of The Evidence-Based Investor. He works as a journalist, author and consultant specialising in finance and investing. He is the co-author of two books, Invest Your Way to Financial Freedom and How to Fund the Life You Want, and his company Regis Media provides high-quality video content for advice firms and other financial businesses.

    

   ALSO BY ROBIN POWELL

   A watershed moment for UK financial advice

   There’s hope yet for St James’s Place

   Private credit has its dangers — caveat emptor

    

   CONTENT FOR ADVICE FIRMS

   Through our partners at Regis Media, TEBI provides a wide range of high-quality content for financial advice and planning firms. The material is designed to help educate clients and to engage with prospects.  

   As well as exclusive content, we also offer a wide range of pre-produced videos which explain how investing works and the valuable role that a good financial adviser can play.

   If you would like to find out more, why not visit the Regis Media website and YouTube channel? If you have any specific enquiries, email Robin Powell, who will be happy to help you.

    

   © The Evidence-Based Investor MMXXIII

    

    

2. Lack of persistence suggests performance owes much to luck

   May 25, 2023 8:50 am Comments Off on Lack of persistence suggests performance owes much to luck

    

    

   If you’ve ever read a prospectus (or, for that matter, an S&P DJI research report), you know that “past performance is no guarantee of future results”. At one level, if you understand that, you understand the most important thing about S&P DJI’s Persistence Scorecards. For the U.S., Europe, Latin America, and Canada (with Australia coming soon!) our recently released Persistence Scorecards are unanimous in showing that historical outperformance is not a predictor of future outperformance.

   At a deeper level, why do we care? We know from SPIVA and other data that most active managers underperform most of the time. But even in the most challenging years, there is a range of active performance results; some managers will always do better than others, regardless of how many outperform passive benchmarks like the S&P 500. Do the top performers get there because of genuine skill or merely because of good luck?

   There is, after all, no theology that precludes the existence of a (presumably small) subset of genuinely skilful active managers. If such a group existed, how would their abilities be evidenced in performance data? As a thought experiment, we can consider a hypothetical set of managers who achieve above-median performance in a particular period, and ask how they perform in subsequent periods.

   If every above-median manager in period one got there simply by being lucky, we would expect half of them to be above median again in period two. If the repeat-success rate were substantially above 50%, we might begin to suspect that the above-median managers were genuinely skilful. But if fewer than 50% of the period one successes were above median in period two, that would support the view that their period one success was due to luck. If we understand something about persistence, we may be able to make inferences about manager skill.

   And that is exactly what the Persistence Scorecards let us do. Exhibit 1 illustrates, using 10 years of U.S. equity data and asking to what degree above-median performance in the first five years predicted above-median performance in the second 5 years. The answer is: not at all. In every fund category, the winners in years 1-5 were unlikely to repeat their success in years 6-10.

    

   

    

   There are, of course, other ways to test for persistence. We could examine performance relative to a benchmark rather than to a peer group, with different lookback periods (one year or three years rather than five years), with different cutoffs (quartiles rather than halves), and for different asset classes (bonds as well as stocks). Our Persistence Scorecards do all of these things and, mutatis mutandis, the results are the same.

   Results produced by genuine skill are likely to continue, while those due to luck are likely to prove ephemeral. The data suggest that good active performance often owes more to luck than to skill.

    

   CRAIG LAZZARA is Managing Director and Global Head of Index Investment Strategy at S&P Dow Jones Indices.

    

   PREVIOUSLY ON TEBI

   Second Lives — a new series on The TEBI Podcast

   True financial freedom is having enough

   The active managers who invest their own money passively

    

   FIND AN ADVISER

   The evidence is clear that you are far more likely to achieve your financial goals if you use an adviser and have a financial plan.

   That’s why we offer a service called Find an Adviser.

   Wherever they are in the world, we will put TEBI readers in contact with an adviser in their area (or at least in their country) whom we know personally, who shares our evidence-based investment philosophy and who we feel is best able to help them. If we don’t know of anyone suitable we will say.

   We’re charging advisers a small fee for each successful referral, which will help to fund future content.

   Need help? Click here.

    

   © The Evidence-Based Investor MMXXIII

    

    

3. Active outperformance: is it luck or skill?

   May 15, 2023 2:31 pm Comments Off on Active outperformance: is it luck or skill?

    

    

   When an active manager outperforms, is it down to luck or skill? The simple answer is that it’s very hard to tell, especially over shorter timeframes. It’s possible to outperform over, say, a year or two, through simple random chance. To demonstrate genuine market-beating skill, managers really need to deliver active outperformance consistently over long periods. And, as CRAIG LAZZARA and DAVIDE DI GIOIA from S&P Dow Jones Indices explain, the latest SPIVA Persistence Scorecard for the United States, shows us, once again, that evidence of genuine, repeatable skill is in very short supply.

    

   “I don’t know any investors who shouldn’t act as if markets are efficient.”

   — Eugene Fama

    

   Strong theoretical arguments and extensive empirical data support the expectation that most active managers should underperform most of the time. But most active managers are not all active managers, and most of the time is not all of the time. When we observe active management success, how can we tell whether it is the product of genuine skill or merely the result of good luck? One answer is that results produced by genuine skill are likely to persist, while those due to luck are likely to prove ephemeral.

   The Persistence Scorecard is designed to address this question. Our report for year-end 2022 finds little evidence of persistent active management success, despite considering a variety of metrics and lookback periods. Exhibit 1 illustrates the general point, using ten years of return data for U.S. equity managers.

    

   

    

   Following Report 6, we consider the above-median managers in each fund category for the first five years, and then ask what fraction of the initial set of top managers repeated their above-median performance in the second five years. If performance were completely random, we would expect 50% of the winners in the first five years also to win in the second five years; if substantially more than 50% of the winners repeated in the second interval, that might be evidence of consistent skill. Results, however, fell well short of this mark.

    

   Report highlights

   Results of the U.S. Persistence Year-End 2022 Scorecard are broadly consonant with those of prior years, despite 2022’s relatively benign environment for active U.S. managers. A declining market, the underperformance of mega-cap stocks, record sectoral spreads and above-average dispersion all militated in favor of active management, and yet 51% of large- cap U.S. equity funds lagged the S&P 500. That most active managers underperformed in what might have been a favourable milieu helps explain why consistent value added, while much desired, is seldom observed.

   • Only 5% of the above-median large-cap active equity funds in calendar year 2020 remained above median in each of the two succeeding years. (If outperformance were purely random, we would expect a 25% repeat rate.) We see similar results for other fund categories (see Report 1).
   • Of 2020’s top quartile large-cap funds, none continued in the top quartile for the next two years (versus 6.25% random expectation). These results were echoed in other fund categories (see Report 1).
   • Consistent value added was just as elusive as consistently good peer group rankings. Outperformance by active managers in 2020 did not predict outperformance in the two subsequent years (see Report 1b).
   • Results for active fixed income managers were somewhat better than for their equity counterparts, although still typically below the level suggested by chance (see Report 7).
   • We continue to find evidence of persistence at the unfavourable end of the distribution. For example, 28% of all fourth quartile U.S. equity funds (based on 2012-2017 performance) were merged or liquidated within the next five years. The comparable figure for top-quartile funds was only 10%. Results for active fixed income funds were similar (see Reports 5 and 11).

   READ THE FULL REPORT HERE

    

   Luck or skill — what’s YOUR view?

   So what do you you think? When an active manager outperforms, is it generally down to luck or skill? Follow us on social media and join the debate. We would love to hear your views. We’re on Twitter, LinkedIn, Facebook and YouTube.

    

   PREVIOUSLY ON TEBI

   The active managers who invest their own money passively

   Should you be impressed by an award-winning fund?

   Buffett and Munger: lessons on money, investing and life

    

   ROBIN POWELL SPEAKING IN LONDON ON WEDNESDAY

   TEBI founder Robin Powell and his co-author Jonathan Hollow will be speaking about the murky world of investment fees and charges at a small event in central London at 5.30pm this Wednesday, 17th May 2023.

   They’ll be explaining you may be paying for a nice retirement for people you don’t even know, and what you can do start funding YOUR dream life instead.

   There are still a few places left:

   BOOK HERE

    

   © The Evidence-Based Investor MMXXIII

    

    

4. Do concentrated active managers produce higher returns?

   April 11, 2023 12:40 pm Comments Off on Do concentrated active managers produce higher returns?

    

    

   It’s often suggested that, if you’re going to use active funds, then you need to look for concentrated active managers who take large positions in a small number of stocks. But is it actually true? CRAIG LAZZARA from S&P Dow Jones indices explains why you may need to think again.

    

   Anyone familiar with our SPIVA Scorecards will recognise that most active managers fail most of the time. Anyone familiar with active managers will recognise that they can be quite creative in proposing both  excuses and remedies for this historical record. One of their most persistent suggestions, in fact, is that active management simply isn’t active enough, leading some asset owners to search for more exposure to concentrated active managers.

   This approach is misdirected for at least three reasons:

   First, it assumes that the level of a manager’s optimism about a stock predicts its future performance. The argument for concentration necessarily implies both that stock selection skill exists, and that it is particularly acute at its extremes. Not only, for example, must a manager be able to build a 50-stock portfolio that will outperform, he must also be able to identify which ten stocks of the initial 50 are the best of the best. For concentrated portfolios to outperform, both assumptions — that skill exists, and that it is acute at the extremes — must be true simultaneously. There is no evidence that either of them is. If it exists at all, the requisite skill must be quite rare. If this were not so, active funds would not be facing a performance challenge in the first place.

   Second, under reasonable assumptions, concentrating equity positions raises the probability of underperformance. One of the most consistent characteristics of global equity markets is that returns are positively skewed — when graphed, they have a long right tail, as shown in Exhibit 1. This is intrinsically logical, since a stock can only lose 100%, but has unlimited upside.

    

   

    

   For the 20 years ending in 2022, the median return of S&P 500 members (during their index membership) was 93%, far below the average return (390%). Only 31% of the index’s constituents outperformed the average stock. In such a market, a manager’s success is dependent on his ownership of a relatively small number of strong performers. The more concentrated a portfolio is, the less likely it is to own the big winners.

   Third, concentrated portfolios make it harder to distinguish between signal and noise. While some managers may be skilful, none is infallible. A manager who is skilful but not infallible will benefit from having more, rather than fewer, opportunities to display his skill. A useful analogy is to the house in a casino: on any given spin of the roulette wheel, the house has a small likelihood of winning; over thousands of spins, the house’s advantage is overwhelming.

   Skilful managers sometimes underperform; unskilful managers sometimes outperform. The challenge for an asset owner is to distinguish genuine skill from good luck. The challenge for a manager with genuine skill is to demonstrate that skill to his or her clients. The challenge for a manager without genuine skill is to obscure his or her inadequacy. Concentrated portfolios make the first two tasks harder and the third easier.

    

   CRAIG LAZZARA is Managing Director and Global Head of Index Investment Strategy at S&P Dow Jones Indices.

    

   This article was first published on the Indexology blog.

    

   MORE FROM S&P DJI

   For more valuable insights from S&P Dow Jones Indices, you might like to read these other recent articles:

   S&P and MSCI US indices: why the difference in performance?

   Putting the improved performance of US active managers in perspective

   Facts do not cease to exist because they are ignored

    

   CONTENT FOR ADVICE FIRMS

   Through our partners at Regis Media, TEBI provides a wide range of high-quality content for financial advice and planning firms. The material is designed to help educate clients and to engage with prospects.  

   As well as exclusive content, we also offer a wide range of pre-produced videos which explain how investing works and the valuable role that a good financial adviser can play.

   If you would like to find out more, why not visit the Regis Media website and YouTube channel? If you have any specific enquiries, email Robin Powell, who will be happy to help you.

    

   © The Evidence-Based Investor MMXXIII