April 2006: Luck vs. Skill: What Are the Chances?

LUCK VS. SKILL: WHAT ARE THE CHANCES?

Not all chefs are of equal ability, or baseball players, or surgeons. Some are better than others. The same applies to mutual fund managers --- some are better than others. Part of our job is to identify exceptional managers and harness their abilities to enhance your investment returns and the protection of your portfolio.

The following is a discussion about distinguishing the best from the rest, their traits and characteristics, and some recent studies that provide further evidence and support to our own findings and investment strategy.

FLEXIBILITY IS BENEFICIAL TO SKILLED FUND MANAGERS

We have found flexibility to be a common trait among the best balanced fund managers. Skilled managers that are given the leeway to invest in whatever they believe is best suited to achieving their investment objectives tend to produce better investment results than if they are confined to a narrower choice of investments.

Craig Callahan and Thomas Howard ("Outside the Box," Investment Advisor Magazine, September 2005) used exhaustive statistical analyses to confirm that mutual fund managers with more latitude and fewer constraints in their investment policies outperformed, by about 3% per year, managers that were limited in the types and styles of investments they were permitted to choose from while managing a mutual fund. Constraints are not conducive to capitalizing on a good fund manager’s skills. Investment constraints and restrictions are likely to impede a skilled manager’s ability to perform at their highest level.

The results of our selection process finds a disproportionate number of fund managers that have the liberty to choose investments from a very wide spectrum of investments --- stocks, bonds, preferred stocks, convertible bonds, industrial metals, real estate, commodities and cash --- including companies of all sizes from all over the world. We believe this is an important aspect of being able to roll with the punches to protect investment capital in bad markets and reap profits in good markets. Flexibility unleashes and reveals a good fund manager’s true capabilities, allowing their talents to be fully utilized and help them to achieve better investment results than their peers.

"WINNING IS A HABIT" – VINCE LOMBARDI

Standard and Poor’s, in their recently released report, Mutual Fund Performance Persistence Scorecard, analyzed how many stock mutual funds were able to maintain above average performance (top 50%) for three and five consecutive one year periods. They also looked at funds that were able to maintain a top-quartile (top 25%) performance. Their findings are logical and intuitive — the good performers are a minority, and maintaining superior performance is difficult.

Of greater interest, however, is they found there was a “persistence” factor among the winners. Winners were more likely to be winners in subsequent years and, therefore, losers were more likely to be losers in subsequent years. This pattern could not be dismissed as a matter of luck. That’s no surprise to us. It takes more than luck to be among the best for multi-year periods. Manager skill makes a difference in how a fund has performed in the past. Logically, we believe it is also a factor in the likelihood of a fund performing well in the future.

LUCK VS. SKILL: WHAT ARE THE CHANCES?

Have you ever looked at a top performing mutual fund and wondered how much of their performance during the past year was a matter of luck and how much was a matter of skill? The random chance of any single mutual fund manager being above average in any single year is 50/50, the same as flipping a coin. Similarly, the random chance of being in the top third is one in three (33%).

But, when you are faced with making several selections, as in selecting a portfolio of mutual funds instead of just one fund, the impact of random luck is greatly minimized and the importance of selection skill increases dramatically. Let’s apply this to picking a portfolio of mutual funds. If you were choosing ten funds, the random chance of having eight of them be in the top 50% over the next year would be just 5%, or one in twenty. (Attention math geeks -- these binomial probabilities can be verified at http://faculty.vassar.edu/lowry/binomialX.html.) If you raise the bar to selecting funds in the top 33%, the random chance of selecting eight funds in the top third (33%) is dramatically smaller at just one-third of one percent (0.34%), or a one in three hundred probability.

How did Asset Allocation Advisors’ fund selection stack up in 2005? Eight of our ten largest mutual fund holdings performed in the top 33% of their peer group in 2005, a feat that could be attributed to luck just once in three hundred attempts. We can’t predict the future, and everyone knows that past performance doesn’t guarantee future performance, but we think that this is a strong indication that our investment strategy and mutual fund selection process is working very well.

"Eight of our ten largest mutual fund holdings performed in the top 33% of their peer group in 2005, a feat that could be attributed to luck just once in three hundred attempts."

It is important to recognize that even the very best mutual fund managers, with ten year rankings in the top 1%, will occasionally have an off year and be below average. In fact, we know of no balanced fund manager, including our own selections, that has a history of always being in the top half of their peer group every single year during the past ten years. Being above average consistently (meaning most of the time) is no small feat for a mutual fund manager. It is neither easy nor common for a mutual fund manager to deliver above average performance consistently, but we believe it can be done and our job is to identify those exceptional funds.

CLOSING THOUGHTS . . .

The enhancements made to our investment strategy in late 2004 have been profitable for your portfolio (and our company pension, too). We continue to research and explore methods that can strengthen and improve our investment process and, in turn, strengthen and improve the results we provide to you in the future. We take our commitment and responsibilities to you in earnest. Thank you for the trust and confidence you have placed in us. We look forward to navigating your portfolio in the years ahead. ***

Greg Schultz & Bruce Grenke
© 2006 Asset Allocation Advisors, Inc.