Previously in this column, we discussed how to choose between active and passive funds for goal-based investments, applying pain and pleasure as behavioural factors. Here, we discuss why you should be mindful of the role of luck in your choice of active and passive funds.

More skill, more luck?

When skill levels improve among market participants, luck may begin to play an important role in the investment outcome. Why? A portfolio’s alpha (the difference in returns between a portfolio and its benchmark index) is a function of a manager’s skill and luck. Therefore, the variation in alpha among funds following similar investment style over a given period is a function of the variation in skill levels and luck.

Now, consider the skill levels in the asset management industry. Over the years, analysts and portfolio managers have gained professional credentialing that has significantly cut the variation in skill levels required to manage portfolios. Also, changes in market regulations have substantially reduced information asymmetry among market participants — investors typically receive the same level of information required to make an investment decision.

Yet, variation in alpha exists. If the variation in skill has tapered, variation in luck must be dominating, given the variation in alpha has not reduced significantly. This does not mean skill is not important anymore. It does mean you must be mindful of the role of luck in investment decision making. But how does this help in choosing between active and passive funds for your goal-based investments?

Conclusion

Passive funds expose you to market risk — the risk your investments may not earn the return entailed to achieve life goal due to a dip in the fund’s benchmark index. An active fund, apart from market risk, exposes you to active risk— the risk of the fund underperforming benchmark index.

There are no doubt about benefits of investing in active funds. However, luck plays a crucial role even with investments in passive funds; the market must rise during the time horizon for life goal. With active funds, you also want the fund manager to have good luck and generate alpha during this period. But you can simplify the above argument by looking at one factor — your luck in identifying the right fund manager (for active funds) and the market rising during the time horizon for life goal ( both active and passive funds)!

(The author offers training programme for individuals to manage their personal investments)

Related Topics