Features | Education | 8 Mins Read | by AG Latto
What drives the performance of active funds? It is a combination of luck, risk-taking and skill. But only skill endures.
Strong active fund returns are almost always attributed to skill – it is the easiest explanation and requires no further analysis.
If skill drives performance, we should buy the top-performing funds – performance chasing. However, luck and risk-taking also drive returns.
Luck cannot last forever while risk-taking eventually goes awry. As the disclaimers warn us, past performance does not guarantee future results.
If we invest in active funds, we should understand the role of luck, risk and skill.
I want to believe
We want to believe that a fund will continue to perform well. We want to believe that outperformance has been due to skill.
Strong past performance leads to a fear of missing out (FOMO). Who doesn't want to join the party?
Skill is a convincing explanation: Fund manager stock selection appears to be solely responsible for fund performance.
Luck, risk & skill
Skill is evident in long-term performance. To identify it ahead of time we can eliminate luck and risk-taking. Or we can look for evidence of skill in the investment decisions.
What appears to be investment skill is often just a tailwind that eventually disappears.
Luck – Starting date, big winners, market cap and style
A value-focused fund starting before 2000 would have avoided the dot-com crash. This has allowed them to outperform since inception despite underperforming from 2003.
One or two big winners can be due to luck. Tesla’s share price increased by 743% in 2020, providing a major boost to growth funds. Tesla could have gone either way.
Market cap positioning can also drive returns. A UK fund focused on mid-caps will do well if mid-caps do well. This will change when UK mid-caps underperform.
Investment styles go through cycles. The growth style benefited from interest rate cuts in 2020. The quality investing style benefited from a gradual increase in valuations until 2022.
We underestimate the role of luck as a medium-term return driver.
Risk-taking – Stocks, sectors, and valuations
Risk-taking is like a racing driver taking it to the limit. While it may work for several races they will eventually crash. While winning, they will be applauded, and risk will be ignored.
Funds can outperform through risk-taking and luck. But they will eventually experience large drawdowns which give the game away.
Risk-taking includes betting on early-stage companies, a few sectors and stretched valuations. Aggressive funds ride bull markets until the music stops – after which they can blame drawdowns on ‘market conditions.’
Risk-taking is a form of ‘cheating’ because the outperformance will eventually reverse.
Skill – Stock picking and risk management
Everyone wants to find ‘the next Warren Buffett.’ Investment magazines seek them out. Nearly all these ‘next Warren Buffett’ investors don’t live up to the hype.
Skill is evident in stock selection rather than a style/valuation tailwind, risk-taking or luck. We can also look for a pattern of consistent outperformance rather than large, one-off gains.
Skill is easier to identify in sector-neutral and style-neutral funds. Good risk management means that excessive risk-taking hasn’t been a factor.
Skill is evident in a broad array of winners and avoiding losers i.e. the batting average or slugging ratio.
Case study: ARK Innovation ETF
Was ARK Innovation ETF (ARKK) lucky, risk-taking or skilful? From November 2014 to today, ARK Innovation is behind the Nasdaq 100 and the S&P 500. These are lower-risk indices that are dominated by established blue-chip stocks.
The return profile suggests that ARKK ETF took significant risks and got lucky in 2020. Its luck ran out in 2022.
ARK Innovation – Its luck has run out
ARKK focused on early-stage companies in the tech sector. It held concentrated positions and let valuations go to the moon.
ARK Innovation did select some big winners. But Tesla may have been luck given the hit-or-miss nature of the company. The fund also sold Nvidia near the bottom in 2022 and has held a series of early-stage losers.
Excessive risk-taking eventually goes awry.
Source: X (The original Tweet has been deleted).
ARK Innovation – A business success story?
A fund that loses money for investors can be a fantastic business.
From a business perspective, ARK Innovation ETF has been a success story. At the end of 2023, ARK Innovation had $9.34bn in assets and had a 0.75% expense ratio – $70m in annual fees.
Fund investors are sticky as they wait for a recovery and continue to view a manager as skilful – Stockholm syndrome? Investors are unwilling to accept that past returns were not due to skill.
According to Morningstar, ARK has been the biggest wealth-destroying family of funds over the last 10 years with $14.3bn of wealth destroyed. The ARK Innovation ETF has been responsible for $7.1bn of this figure.
“It’s easier to fool people than to convince them that they have been fooled.” – Mark Twain
Performance and media attention
If we have been conditioned to believe a fund manager has skill it can be hard to change our minds. This is true of the financial media and investors.
The margarine brand "I can't believe it's not butter!" was named after a comment from someone sampling it. For many active funds, we can change this to "I can't believe it's not skill!"
I can't believe it's not (Butter) Skill!
Top-performing fund managers attract media attention: ‘Please tell us the secret of your success.’ Weak subsequent returns can be blamed on any number of factors.
Once a fund manager is a ‘media star’ they will be asked for their two cents even if past outperformance has become underperformance.
Summary
By the time it is evident that a manager lacks skill, it will be too late. A drawdown is a painful way to learn that past returns were due to risk-taking and luck.
It pays to ask what has driven active fund returns ahead of time. The 2020 growth stock boom created more than a few ‘bull market geniuses.’
Additional comments:
Some further thoughts.
1) The financial media on funds
The financial media tends to attribute strong returns to skill and poor returns to bad active management. It would be preferable if the role of luck and risk-taking were also questioned.
Risk-taking funds that get lucky are described as skilful. But excessive risk-taking should have been obvious at the time. The two questions the media should ask are:
- Has this fund taken more risk than the market?
- Has this fund benefited from a tailwind? I.e. been lucky.
2) Replication
Some funds may have done well in a way that we can replicate ourselves. For example, they may be overweight in the technology sector or mid-caps. Do we need to pay active manager fees for this?
Some investment funds have done well recently by being overweight in the technology sector. But we could have done this ourselves at a lower cost and lower risk.
3) Active versus passive
This article doesn’t touch on this question. If we go for active funds, we want them to be skilful. Past performance is not a sufficient guide to future success given the role of luck and skill.
4) Risky fund launches
The success of ARK Innovation shows that it can pay to launch risky funds. This is one reason the active fund industry launches a steady stream of high-risk, niche funds. They only need to get lucky with one of them.
5) ARK Investments
It is unfortunate to pick one fund manager for a case study. But ARK Investments is well-known and well-followed. They claim they are set to generate strong returns, but 10 years is a reasonable period to form a view on them.
ARK Investments has got far more media attention than any other growth fund manager in recent years.
6) It is easy to judge ARK Innovation now
Looking back to early 2021, it would have been harder to have a negative view. ARK Innovation had returned 149% in 2020 largely due to successfully picking Tesla.
ARK’s founder Cathie Wood was in the media and the case for ‘innovation investing’ seemed very strong. Fear of Missing Out (FOMO) can wreak havoc on our emotions and ability to act rationally when looking at the chart below.
Applying the three return drivers, – luck, risk-taking and skill – it was clear back then that ARK Innovation had taken a lot of risks. It had also been lucky due to the pandemic boosting growth stocks and Tesla being a big hit.
The luck, risk-taking and skill framework could have saved investors from ‘performance chasing’ losses in ARK Innovation.
ARK Innovation – The urge to buy the fund in 2020 would have been strong
7) ARK Innovation and Stock Selection
Good stock selection within an area is evidence of skill. ARK Innovation did very well with Tesla, but it has also picked lots of early-stage losers – perhaps it just got lucky on Tesla?
An investment strategy that makes risky bets will inevitably have one or two that work out well. But this is not evidence of skill. What matters is the overall returns. Exiting of Nvidia at the bottom is not indicative of investment skill.
8) Mark Twain quote: It’s easier to fool people than to convince them that they have been fooled.
There is some dispute as to whether Mark Twain said this. He did say this very similar quote: “How easy it is to make people believe a lie, and how hard it is to undo that work again!”
9) Morningstar article
15 Funds That Have Destroyed the Most Wealth Over the Past Decade (February 2nd, 2024)