How can you tell?

It’s well known that people are very keen to find causality in the world, and reluctant to accept that a lot of what goes on is just random. Those of us who’ve been educated properly know that correlation is not causation, but it’s sometimes difficult to put that into practice.

There are some common examples. People who have lucky mascots, or rituals they go through before special events, such as exams or sports matches they are taking part in (or watching, or teams they support are taking part in). To my mind, many business books that use the argument “XYZ Corp did really well under Pat as CEO, Pat has these character traits and behaviour patterns, so if you can develop the same traits and patterns your business will do really well too” are along the same lines. You need a very strong argument that causality is actually present before believing it.

It’s the argument against active fund management, too: if you take a large number managers, one of them will come out top over a year, or indeed over any period you like to mention, even if their performance isn’t affected by their skill. So saying that so-and-so has had consistently good results isn’t a very strong argument that they are actually better at it than anyone else, as opposed to luckier than most other people.

However, even if some fund managers are genuinely skilled, it’s possible for unskilled ones to mimic their performance. Tim Harford explains it well:

… it is possible for an unskilled fund manager to mimic a genuinely skilled one, in the same way that an insect might mimic a leaf, or a harmless creature mimic a poisonous one.

This mimicry, too, involves three steps: first, invest all your funds in whatever benchmark you need to beat, whether it’s treasury bills or a stock market index; second, make a bet that some unlikely event will not come to pass using the invested funds as security; finally, boast of benchmark beating returns, because you’ve delivered the benchmark plus the additional money from winning the bet. Collect your performance fee. (In the unlikely event that you lost the bet and with it all your investors’ cash, simply cough awkwardly and look at your shoes.)

It turns out that it’s impossible to tell the difference between this and a more conventional strategy just by looking at the investment returns.

These are the “black swans” made famous by Nassim Taleb: low probability, high-impact events, except that these particular swans are genetically engineered – deliberately manufactured and then hidden away, to escape at unwelcome moments.

Harford goes on to explain how these mimicking strategies can be used to game nearly all bonus schemes based solely on performance.

This suggests an obvious question: is this in fact a surer way of getting good investment performance than relying on skill anyway?