BattleBots is a TV series that originally ran in the early 2000s and was revitalized last year. (I recently saw that it’s on again this summer!) If you aren’t familiar with BattleBots, it’s a show that has inspired viewers of all ages (including yours truly) to dream about or even dabble in robotics, engineering, and creative design. The premise is simple: An elimination tournament pits robots, built and operated by the competitors, against each other. The robots take seemingly countless forms as the entrants look for any edge over their competition. And season after season, the skill levels and sophistication of designs continue to increase.
Each episode, I find myself thinking wishfully about what I would build to dominate the competition. The problem with this, of course, is that I have neither the requisite skills nor materials. Fortunately, I recognized early on that in the range of engineering and design skills among all people, I am at the far left side. Conversely, those competing in the BattleBots’ tournaments are at the far right end (see figure below). Relative to the average person, these professionals are highly skilled, with access to technology, equipment, and processes that the rest of us don’t possess. This disparity would no doubt end very badly for me (or my ‘Bot as it were), as my opponent would take advantage of my ineptitude quickly and without mercy. As a result, I watch and do not participate!
In investment management, this would be known as easy alpha—the kind that investment professionals dream about. Unfortunately, easy alpha is only a dream. This is because the vast majority of portfolio managers, traders, investment experts, and analysts are highly educated and credentialed, have access to the latest technology and information, and have expert knowledge of the financial markets. In other words, we in the investment management industry dominate the far right tail of the investment management talent distribution among all people (like the engineering distribution above). This means that investment professionals are not competing against unskilled know-nothings but rather other highly skilled and motivated counterparties who are also at the far right tail of the talent distribution. As a result, operational or execution advantages are difficult to consistently come by.
This is where it gets interesting. Performance is a zero-sum game (before costs), meaning that for every outperformer, there must be an underperformer. It would be great if active managers could systematically take advantage of unskilled investors so that as a group, they were the outperformers and the unskilled were the underperformers. But alas, since the capital markets pit talent against talent, if one talented PM wins, another talented PM has to lose. And it’s not even as simple as half win and half lose. In fact, most active managers incur significant costs to ply their talents in their effort to win, ultimately falling to the losing side of the performance scale when measured against costless benchmarks and low-cost index funds, even if they would have outperformed before costs. This combination of talent versus talent and the perpetual drag and compounding of costs is why performance results look so poor on average for active managers, particularly over the long run.
The challenge for investors using active managers, therefore, is to identify why a particular manager should have an enduring and replicable advantage in a highly competitive market. Working with a team dedicated to the pursuit of talent discovery, such as Vanguard Portfolio Review Department, can provide advantages in sifting through data but must be supplemented with investor patience, conviction, and acceptance of potential underperformance. Further, focusing on the attributes that matter the most—cost being the most powerful—is critical (but by no means a guarantee). We believe this combination can improve the odds of outperforming even if there is no silver bullet.
Ultimately, whether entering a BattleBots’ tournament or engaging in active management, it’s critical to understand who the competition is and the significant challenge of overcoming that competition. Because of this, for investors looking to maximize the efficiency of their portfolio, there is a clear role for focusing on cost and incorporating indexing. Be sure to check back for my thoughts on these last two points in upcoming blogs.
- All investment is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
- Past performance is no guarantee of future results.