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The ‘Paradox of Skill’ Adds to Active Management Woes

Luck is becoming more important as “available alpha” appears to be shrinking, says Michael Mauboussin of Morgan Stanley Investment Management.

The paradox of skill is making life even harder for active asset managers — particularly stock pickers, according to Michael Mauboussin of Morgan Stanley’s investment management unit.

“Since the financial crisis in ’08, investors have withdrawn $1.8 trillion from active management and added $2 trillion to passive,” Mauboussin, head of consilient research (i.e., connecting principles from different disciplines) at Morgan Stanley’s active fundamental equity group Counterpoint Global, said September 16 at the Morningstar Investment Conference. The shift has accelerated as most stock pickers fail to consistently beat their benchmarks after fees, he said. Simultaneously, “available alpha” appears to be shrinking due to the paradox of skill: the notion that “luck becomes more important” as skill in a field increases and becomes more uniform.

In his view, active managers are facing stiffer competition as their struggling peers give up the battle with passive funds that beat them by tracking indexes.

“The people left at the table are actually the smartest players,” Mauboussin said. “Your task as an active manager just got a lot harder.”

The paradox of skill is a phrase Mauboussin said he learned from the late eminent biologist Stephen Jay Gould. The concept applies to any domain, including business and sports, and considers skill on an absolute and relative basis, he said. Relative skill is particularly important, he said, because as the gap between the “very best” and average participants shrinks, excellence becomes more uniform.

For example, the stellar batting average that Hall of Fame baseball player Ted Williams achieved decades ago is even harder to repeat today, according to Mauboussin. Williams, who played for the Boston Red Sox, was the last player in major league baseball to hit over .400 in a season — an accomplishment dating back to 1941.

A similar standard deviation in major league baseball last year translates into a batting average of around .350 to .370, according to Mauboussin. That’s “fantastic,” he said, “but doesn’t get you anywhere close to the .400 threshold.”

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For all their struggles today, active managers remain important because they make markets more efficient by encouraging price discovery and they provide liquidity by turning cash into an asset and vice versa, according to Mauboussin. He said indexers benefit from this and “are essentially free-riders.” 

Actively managed funds are more expensive than the index products, which is partly why investors have been flocking to passive managers. Paying higher fees for disappointing performance becomes hard to justify.

“In a very real sense, the fees paid to active managers subsidize index funds” as well as “people in the rules-based investment community,” Mauboussin said.

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