Is Your Manager Skillful…or Just Lucky?

There's no way to be sure, but Michael Mauboussin offers pointers on how to sort it out

Investors can track, to a hundredth of a percentage point, how individual mutual funds are performing relative to their market benchmarks. But they are largely powerless in determining the degree to which a fund manager's results are a function of skill—and how much they are attributable to just plain luck.
To explore that, we spoke with Michael Mauboussin, the chief investment strategist at Legg Mason Inc.'s LM +2.63% Legg Mason Capital Management unit and the author of a new book, "The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing."
The following are edited excerpts of the conversation with Mr. Mauboussin, who has worked at the fund-management firm since 2004 and has been an adjunct professor of finance at Columbia Business School for 20 years.

Abundance of Skill

WSJ: In the book, when you put certain activities on a continuum from being all luck to all skill, you show investing as having a much larger quotient of luck than winning at football or baseball or chess. You say that is partly because so many smart people play the investing game?

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Andrew Kist

Michael Mauboussin

Mr. Mauboussin: Exactly. It's very counterintuitive. The key is this idea called the paradox of skill. As people become better at an activity, the difference between the best and the average and the best and the worst becomes much narrower. As people become more skillful, luck becomes more important. That's precisely what happens in the world of investing.
The reason that luck is so important isn't that investing skill isn't relevant. It's that skill is very high and consistent. That said, over longer periods, skill has a much better chance of shining through.
In the short term you may experience good or bad luck [and that can overwhelm skill], but in the long term luck tends to even out and skill determines results.
WSJ: You say people generally aren't very good at distinguishing the role of luck and skill in investing and other activities. Why not?

Michael Mauboussin

Mr. Mauboussin: Our minds are really good at linking cause to effect. So if I show you an effect that is success, your mind is naturally going to say I need a cause for that. And often you are going to attribute it to the individual or skill rather than to luck.
Also, humans love narratives, they love stories. An essential element of a story is the notion of causality: This caused that, this person did that.
So when you put those two together, we are very poor at discriminating between the relative contributions of skill and luck in outcomes.
WSJ: If I accept that a big part of investing success is luck, not skill, isn't that a strong argument to simply go with index funds and not try to pick active managers?
Mr. Mauboussin: Indeed. For someone who has little motivation to try to identify those who have differential skill, indexing makes a lot of sense.

Spotting a Winner

WSJ: Is it possible for individual investors to identify in advance mutual-fund managers who are truly skilled and not just lucky?
Mr. Mauboussin: You can make a credible effort if you are motivated, yes.
A manager may do the right things and get bad outcomes or do the wrong things and get good outcomes. So investment results can be very deceptive.
The better way to do it is to focus on the process of decision making that managers use and to look for numerical measures that can be proxies for that.
The one that is the most interesting candidate currently is "active share." Active share is a measure of how different your portfolio is than the benchmark to which you are compared.
We are now taking a concrete step toward trying to identify process versus simply results.
WSJ: You joined Legg Mason near the end of Bill Miller's 15-year streak of beating the Standard & Poor's 500-stock index with his Legg Mason Capital Management Value Trust, which was followed by years of poor performance.
How much of his strong investment performance was just good luck?
Mr. Mauboussin: If you look at streaks, not just in investing but in any endeavor, almost by definition they combine skill and luck. You have to have above-average skill and above-average luck to have a streak. If you look at it in the realm of sports, all the streaks are held by the most skillful players, although not all skillful players have streaks.
When Bill has been posed this question, he has attributed a good chunk of his streak to luck.
It is almost axiomatic that that has to be true.
WSJ: Is it also possible that some of the really awful results more recently [before Mr. Miller stepped down as portfolio manager earlier this year] were bad luck?
Mr. Mauboussin: Yes, it's very likely that was a substantial contributing factor.