The job of picking winning investment managers has become more difficult over time. A primary reason for the increased difficulty in picking winners is the “paradox of skill”.* It is not that investment fund managers are not skilled. Conversely, it’s that the skill level has risen to very high levels across the financial industry.
It is akin to what has happened in the NFL where on any given Sunday any team can beat any other, and a dynasty in the NFL is a rarity (without cheating – looking at you Patriots). Each and every individual in the NFL is very skilled, but their competitors are equally skilled in most cases.
The same is largely true in the asset management industry. The lucrative nature of the industry has attracted many of the best and brightest minds. A few years ago I read of an astrophysics professor at Cal Tech who commented that he knew the financial industry was out of control when one of his PhD postdoctoral students scheduled a meeting with him to discuss his various job offers. The professor assumed that they would be discussing offers from places like NASA, Jet Propulsion Lab, University faculty appointments, etc. Instead the student was having trouble deciding between the Carlyle Group (an alternatives manager) and Goldman Sachs. This story is symptomatic of the issue: the skill level in the financial industry is very high. Highly intelligent and analytically skilled students who would have gone into engineering, physics and science in generations past have been choosing finance as their profession because it pays multiples of those other professions.
These highly skilled and educated individuals and firms are competing fiercely against each other and in doing so have ground away much of the ability to gain an investment advantage. The high skill level across the industry leads to one of the reasons that investors still chase returns and add money to high-priced investment managers: it is because they are so impressive. We often comment at our firm after meeting with one of these very skilled investment managers that if they were the only manager you had ever met you’d want to give them all your money.
These managers typically went to elite schools and have elite graduate degrees. They have impressive backgrounds and have decades of experience at blue chip Wall Street firms. Their investment process, philosophy and discipline all appear brilliant and would seem to lead to out-performance. They have stories of their many successes and have multiple products and strategies that have outperformed in the past as proof of their ability. You only truly gain perspective on the industry once you have met with hundreds or thousands of these managers and realize that all these impressive individuals and firms are competing against each other. Again, to borrow from the NFL analogy: if you meet just one NFL wide receiver you would be stunned by his physical abilities and assume he would be very successful. Only after meeting many wide receivers (and cornerbacks) do you come to the realization that its very hard to be successful in the NFL because everybody is highly skilled.
This is the paradox of skill – as the level of skill increases in an industry, the greater the contribution of chance to outcomes and skill provides a benefit to a much lesser (or no) degree.
* A fantastic discussion of the paradox of skill can be found in the book The Success Equation: Untangling Skill from Luck in Business, Sports and Investing by Michael Mauboussin.