Is Asset Management Just a Glorified Lottery?

For one analyst, investing is about three things: process, process, and process.

Gambler Scratching a Lottery Ticket With a Penny
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Investing is not supposed to be gambling, but when you give your money to a fund manager you're exposing yourself to some combination of skill and luck. That's true even for passive index funds, to say nothing of actively managed funds. But how do you know which—skill or luck—will most determine the outcome? And is there a way to ensure that skill plays at least as large a role as luck? If not, is asset management just an elaborate lottery?

It's an age-old question that Legg Mason analyst Michael Mauboussin tackles in his fourth book, The Success Equation: Untangling Skill and Luck in Business, Sports and Investing. He starts with a simple test for discerning where skill matters more than luck: If it's possible to lose at something on purpose, that something involves skill. If it's not possible, the something is a game of luck.

Since your fund manager can't normally lose on purpose, you might be tempted to conclude that he's effectively gambling with your retirement. Indeed, on the luck-versus-skill continuum, Mauboussin places investing closer to roulette than to chess. But Warren Buffett is pretty good evidence that investing outcomes are not purely functions of luck, even if Buffett can't lose entirely on purpose.

How does an investor go about finding fund managers who can be reasonably credited with skill? Two ways, says Mauboussin. You can look at the manager's track record, but reliable track records take years to amass. Better, says Mauboussin, to look at his process. If it's a sound process—picking undervalued stocks, for instance—it should succeed in the long run whatever the short-term vicissitudes of the market.

[Read: Look for Fund Managers Who Eat Their Own Cooking]

Of course, the typical shareholder is wholly unequipped to size up a fund manager's process, which is why Mauboussin and many others recommend index funds for most retail investors. For investors who don't mind wading into some technical weeds, though, Mauboussin suggests some concrete tools.

One is to look at "active share" and "tracking error" together. Active share is the portion of a portfolio that departs from the benchmark, expressed as a percentage (zero represents exact replication of the benchmark and 100 no resemblance at all). Tracking error is the precision with which the portfolio mimics a benchmark index.

There is wide variation in performance among funds with high active share (say, above 60 percent), but those with both a high active share and moderate tracking error tend to generate higher risk-adjusted returns than those with high active share and high tracking error, notes Mauboussin.

Even the view from the weeds doesn't tell you everything, of course. There are lots of ways to look at the interplay of skill and randomness, a subject that has produced a minor publishing industry in recent years exemplified by such popular books as Nassim Taleb's The Black Swan and James Surowieki's The Wisdom of Crowds.

[Read: John Bogle's Dim View of the Asset-Management Industry]

We chatted with Mauboussin recently about some of the concepts central to those books and his—mean reversion, the "paradox of skill" (how a rise in collective skill levels makes luck more, not less, relevant), what makes for a useful statistic, and other questions. An edited transcript:

Even if we agree there is such a thing as investment skill, a typical investor would be hard-pressed to find it. So does it make sense for an average investor to be anywhere other than index funds?

If an investor is not interested in putting some effort into trying to figure out which managers potentially have differential skill, index funds make an enormous amount of sense for most people. Two things I would add, though: First, there is a test in economics called the macro-consistency test, which basically asks the question, "What would happen if everybody does something at once?" Unfortunately, index or passive investing generally fails that test. In other words, not everyone can do it at the same time.