How do you explain to private clients that picking active fund managers in equity markets, or picking advisers who do, is a near-certain route to wealth destruction? Just show how many things have to go right for the extra costs and risks to be rewarded with a better long-term outcome than investing in trackers. I call this the six degrees of implausibility.

I prefer this approach to arguing on the basis of the evidence of randomness versus skill, using actual performance data for the population of active funds investors select from. However compelling the evidence, it can never be proven beyond doubt – which is why active remains the preferred route in retail investment. Whereas breaking active management down into the decisions and behaviours that have to go right can be insight enough. Here are the six levels where skill is tested.

  1. For a portfolio manager to beat the market, he or she needs to be able to make good forecasts of the economic influences on equity markets.
  2. That then needs to be translated into good forecasts of the impact on individual companies’ trading performance.
  3. To turn that into better forecasts of share-price performance requires a correct estimate of the difference between his or her own view and the aggregate opinion of other investors that is already reflected in the current share price.
  4. The final requirement for outperformance by the fund manager is to turn a set of broadly correct opinions about a large number of share prices into the right particular construction of relative weights: differences in exposure to each relative to the proportion each represents in the index.
  5. These are the activities a fund manager succeeds in, if they are skilled. But somebody else has to be skilled enough to identify the skilled fund managers and separate skill from luck. That could be a wealth manager, fund of funds manager or financial adviser. But what about the client himself or herself? Don’t they need the same or similar skill in order to identify whether their appointed agent has the right skill?
  6. Finally, each activity will be tested by the way information comes at us about earlier selections, including stuff that looks like it is information but is really just statistical noise. How each actor reacts to that noisy information flow will determine whether all five selection skills can be turned into sustainable outperformance for your own portfolio. This is itself fraught with questions and a lot of guesswork to answer them. Has the manager lost their touch or did I simply make a mistake? Will I avoid compounding an error by doing nothing? Will I look stupid to the client if this shows up in the ‘dog’ funds list? How long will the picker above me in the list give me to sort it out?

The most destructive behaviour commonly arises at level 6. Thus you or your agent picks funds that have outperformed over recent years. If the process is largely or entirely random, this means there is a high chance the performance will revert to the mean, which happens via a spell of underperformance. If you think you made a mistake but it was limited to this fund choice, rather than in generally choosing active over trackers, the most consistent way to react is to sell and choose another active fund with good past performance. Buy high, watch the mean reversion, sell low, repeat. Instead of cumulative outcomes being no better than chance, but with extra costs, they are now systematically worse than random.

Fancy your chances, on all levels?