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Active management and the paradox of skill


Active management and the paradox of skill

In the world of active equity management, investment managers – ourselves included – seek to “outperform” the broader equity market index. This outperformance is typically referred to as “alpha” in the industry jargon. Of course, alpha can be both positive – when a manager outperforms; and negative – when a manager underperforms.

One thing to keep in mind about active management is that, by definition, the generation of alpha is a zero-sum game. That is, one manager can generate alpha if, and only if, there are other managers out there generating negative alpha. The returns of the global equity peer set below appear to be roughly consistent with this concept: over the last (nearly) four years, approximately half the major global equity managers in Australia outperformed the global equity market; while approximately half underperformed.

Screen Shot 2019-05-16 at 11.11.20 am

Enter the “paradox of skill”. This paradox states that in activities (such as active equity investing) where both skill and luck contribute to outcomes, luck will play a larger role in determining results as skill levels increase.

Have you noticed that, over shorter periods of time, the alpha generation of even skilled investment managers appears somewhat random? This is not because investment managers are not as good as they used to be – indeed, it’s the opposite. The skill level of investors today has increased so much that equity prices do a better job of reflecting relevant information – though mispricings do still emerge from time to time.

If you would like to learn more about the interaction between skill and luck, I would recommend a book written by your author’s former Professor at Columbia University, Michael Mauboussin, called The Success Equation. In addition, Annie Duke’s Thinking in Bets is another must-read to think about decision making in the context of imperfect information combined with luck.


Andrew Macken is the Chief Investment Officer of the Montaka funds and the Montgomery Global funds. He established MGIM in 2015 in partnership with Montgomery.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. Excellent article Andrew.
    Query to you or Roger.
    Given that alpha is a zero sum game, for active managers I would expect a majority to be within the average with a minority of either side to be skewed i.e. a flatter curve with larger rises/falls @ extremes indicating significant deviation from the norm mostly based on investing style.
    i.e. with all the available data to professionals would you be able to hypothesize why there is such an, almost linear, relationship in the performance of active managers around the mean?

    • Hi Joe –
      The zero-sum aspect applies to the thousands of fund managers and millions of individual investors all over the world. As such, the sample set in the chart is not representative enough to put too fine a point on the shape of the return distribution.
      All the best,

    • Peter, They’re in the list provided. If we name who is first, as a service to investors, we should also name who is last because there is potentially value in that information too. But we aren’t about to name who was last. It’s worth remembering that the leader and the last place-getter can change from month to month. SO perhaps there is less value in that information than might first be perceived.

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