How Poker Explains the Battle of Passive and Active Investing

Podcast Summary

• Active vs Passive Investing: A Poker Analogy: The rise of passive investing creates opportunities and challenges for active managers, requiring them to provide value-added services and adapt to remain competitive.

  The debate between active and passive investment management in financial markets can be likened to the dynamic between skilled and weak poker players. Michael Moebison, the head of Global Financial Strategies at Credit Suisse, uses this analogy in a thought-provoking paper he's written on the topic. In poker, weak players may choose to stay at the table, presenting opportunities for skilled players to outmaneuver them and potentially earn higher returns. Similarly, the rise of passive investing, with its lower fees and market replication strategy, presents both opportunities and challenges for active managers. Active managers can potentially differentiate themselves by providing value-added services and insights that passive strategies may not offer. However, they must be prepared to adapt and evolve their strategies to remain competitive in this changing landscape. Overall, Moebison's poker analogy provides a fresh perspective on the active versus passive investment management debate and highlights the importance of agility and adaptability in today's financial markets.

• Active managers face tougher competition with the shift to index investing: The competition for active managers to outperform the market increases as weaker players exit, leaving the table to the smart, motivated, and resourceful ones.

  The shift from active to index investing might not make it easier for active managers to outperform the market as some may assume. In poker terms, the weaker players are leaving the table, but the remaining players are the smart, motivated, and resourceful ones. This means the competition is tougher, and it could be more challenging for active managers to beat the market. Additionally, it's essential to understand that even if there are no free lunches in the market, prices might not always be right, making it difficult to exploit inefficiencies. Active managers need to be aware of these challenges and adapt their strategies accordingly.

• The Challenges for Active Managers in a More Efficient Market: Despite market efficiency, active managers offer value through functions like price discovery and liquidity. To identify effective active managers, consider their track record, ability to beat the market consistently, and evaluate their investment strategies, risk management, and team expertise.

  The rise of passive investing and market efficiency has made it more challenging for active managers to demonstrate their skills. This trend, which has been ongoing for the past decade, can be attributed to the increasing accessibility and affordability of information, regulatory shifts, and technological advancements. However, it's important to note that markets can't be entirely passive, as active managers provide essential functions like price discovery and liquidity. To identify good active managers, it's crucial to consider their track record over an extended period and evaluate their ability to consistently beat the market despite the increased market efficiency. Additionally, it's essential to distinguish between skill and luck, as even a manager with a strong track record may have been fortunate rather than skilled. A potential approach to identifying good active managers could involve analyzing their investment strategies, understanding their risk management techniques, and evaluating their team's expertise and experience. Ultimately, the key is to approach active management with a critical and informed perspective, recognizing the importance of both passive and active investing in a well-diversified portfolio.

• Assessing Manager Skill in Asset Classes: Consider dispersion of returns, past performance adjusted for factors, manager characteristics, fund size and strategy, and manager's skin in the game when evaluating investment managers in asset classes.

  For most individuals, index funds are generally the recommended investment choice. However, when it comes to asset classes, there is potential for expressing skill, particularly in areas with a wide dispersion of returns. To assess a manager's skill, factors such as past performance, manager characteristics, and fund strategy can be considered. Yale's David Swenson emphasizes the importance of evaluating dispersion of returns in asset classes and paying skilled managers accordingly. Additionally, the authors suggest looking at past performance, adjusting it for factors, examining manager characteristics, and considering the size of the fund and strategy. Skin in the game is also important but should not be taken too far, as it can impact a manager's objectivity and responsibilities. Lastly, investing is an activity that involves both skill and luck, and the paradox of skill suggests that as absolute skill increases, luck becomes more influential. It's crucial to consider both absolute and relative skill when evaluating investment managers.

• Skill compression in finance and professional sports: The gap between top and underperforming investors is shrinking, requiring investors to identify skillful managers by examining performance differences across asset classes, industries, and sectors.

  The gap between top-performing and underperforming investors or managers is shrinking due to the increasing efficiency of markets and the high level of skills among participants. This phenomenon, known as skill compression, is evident in various industries, including professional sports and finance. However, it doesn't mean that skill is less important; instead, it highlights the need for identifying dispersion or differences in performance across asset classes, industries, and sectors to express and reward skill. Additionally, the standard deviation of excess returns of mutual funds has decreased over the decades, making it harder for investors to distinguish themselves and find skillful managers. Despite these challenges, it's essential to keep looking for ways to identify and invest in skilled managers to gain an edge in the competitive market.

• Market manias or bubbles indicated by widening dispersion?: Individual investor behavior and smart beta strategies provide insights into market trends, but their reliability as market timing techniques is debated.

  The widening dispersion of stock market returns during certain periods can serve as evidence of market manias or bubbles, but it may not be a reliable market timing technique in real time. Individual participation in markets, particularly mom and pop investors, has been decreasing over the years, and their behavior, such as funds flows, can provide insights into market trends and potential excesses. The effectiveness of "smart beta" strategies, which aim to exploit certain factors for excess returns, is a topic of ongoing debate, with some arguing they are driven by behavioral factors and others by simple funds flows. The ongoing debate between active and passive investing suggests that the returns for both approaches will eventually balance out, and the shift towards passive investing may not necessarily lead to superior returns for active managers. Instead, it's essential to understand the underlying dynamics driving market trends and investor behavior.

• Distinguishing Skill from Luck in Investing: Investors must identify opportunities to outperform the market by understanding their competition, considering non-fundamental factors, and analyzing entities' motivations and capabilities, while acknowledging the inherent underperformance of active management due to higher fees.

  In the world of investing, where 25% of the population is indexed against the S&P 500, the remaining 75% of active managers must also aim to earn the market return. Active managers must identify opportunities to be the "smart player at the table" by competing against individuals, taking advantage of non-fundamental reasons for buying or selling, and considering the motivations and capabilities of entities like corporations and governments. However, it's important to note that active management, with its higher fees, will underperform the index due to the math of the situation. In life, similarly, it can be challenging to distinguish between skill and luck, and self-reflection through the concept of the "luck-skill continuum" can help us better understand our own successes.

• Recognizing the role of skill and luck in success: Success in life and various domains involves a combination of skill and luck. Acknowledging the role of luck is crucial for maintaining perspective and gratitude.

  Success in life and in various domains, including sports and business, can be attributed to a combination of skill and luck. While some activities, like lotteries and roulette wheels, are purely based on luck, most activities fall between these two extremes. For instance, professional sports leagues like the NBA have a higher skill component compared to other sports like Major League Baseball, which is closer to randomness. However, even great performers or positive outliers, such as DiMaggio's 56-game hitting streak, benefit from both skill and luck. Therefore, it's crucial to acknowledge the role of luck in success and recognize that both successful and unsuccessful individuals have been influenced by it. Additionally, being grateful for good fortune and understanding that luck plays a role in most people's lives is an essential perspective to adopt. Overall, this discussion highlights the importance of recognizing the interplay of skill and luck in various aspects of life and success.

• Recording a Podcast at a Casino: The Odd Lots hosts are recording a new podcast, Money Stuff, at a casino and are excited about the experience despite potential challenges from the casino.

  The hosts of the Odd Lots podcast, Tracy Alloway, Joe Weisenthal, and Michael Mobison, had a conversation about their past episodes related to gambling and poker, and they decided to take it a step further by recording a podcast episode at a casino in Atlantic City. However, they acknowledged that casinos might not be fond of recording devices at the table. Despite the potential challenges, they are excited about the idea and encouraged listeners to check out their new podcast, Money Stuff, which is a collaboration between Matt Levine and Katie Greifeld based on Levine's popular Wall Street finance newsletter. The Money Stuff podcast will be released every Friday and can be listened to on various podcast platforms.