The death of investment management skill?

Between talk of shrinking alpha and the death of investment skill, it has been a bad month for active managers. It has only gotten worse if you look at some of their performance numbers for the first part of the this year.

The story has has creditability when you review investment flows. The move to passive indices has continued at the expense of active managers. The long-term argument is that if there is more money in passive investments, the active managers will have more opportunities to generate return, but that argument is not exactly true. The reason is based on the "paradox of skill".

If the number of skill managers either increases or stays the same  relative to the amount of money managed, the alpha gain should be less. More skill players are chasing the same opportunities. Skill is valued on a relative not an absolute basis. The quality of money management has increased based on education and training, but this skill is across the board.

Managers are running faster to stay in the same relative space. We see this is sports. Runners have greater skill now than a generation or two ago. Runners have an absolute performance advantage over the past, but that does not mean any individual runner will win more races today. So what should investors do?

One thing should be obvious. Don't expect to make money with managers who focus on, for example, large cap growth or value. There are too many of these managers looking for the same thing thus creating crowded trades. The traditional active stock bond mangers are in fields that is too crowded.

The alternative is to focus on investment strategies that are more unique and less crowded. Strategies where there is greater dispersion in beliefs will by definition be less crowded and have the opportunity for higher returns based on skill. One of the key reasons we like global macro is that there is less agreement on fair value. Hence, alternative models that create even a small edge have a chance for success.