Bouncing off lessons from World Cup

Like football teams, investment managers require both skill and luck to succeed

With many of us watching the World Cup, we thought it fit to discuss the similarities between football and investments. Our objective is simple: We wish to suggest that football teams and investment managers require both skill and luck to succeed.

Luck? Skill?

Consider the following: First, Messi was arguably the best footballer at the start of World Cup 2018. But his performance for Argentina left a lot to be desired. A good portfolio manager may suffer from an extended period of bad performance. Likewise, a not-so-good portfolio manager may enjoy a streak of good luck and handsome performance.

Second, Italy, four-time winner of the World Cup, failed to qualify for the final 32 for the first time since 1958. Indeed, past performance is no indicator of the future. You can also consider how Germany, winner of the 2014 World Cup, performed in 2018, or how Spain, winner of 2010 World Cup,, performed in 2014. It is similar with investments. Just because a portfolio manager has performed well in the past does not necessarily mean that the manager has to do well in the future.

Third, scoring goals is difficult, especially if a team is already behind. Consider Argentina’s game with France in Round 2. The goals scored by France seemed so easy and in quick time. Argentina laboured through the match to equal the score. Similarly, it is easy to lose value on an investment portfolio. But it is difficult to recover those losses. This relationship, called asymmetric returns effect, clearly shows that recovering unrealised loss is more difficult that giving up unrealised gain of the same magnitude.

Four, which team advances to the Round of 16 is no doubt based on skill. Yet, randomness has a large role to play in a team’s success. How? According to The Guardian, England could have been in a group consisting of Brazil, Iceland and Nigeria. But they were instead grouped with Belgium, Panama and Tunisia. It is moot if England could have had a smooth ride to Round 2 if its opponents were Brazil and Nigeria instead of Belgium and Tunisia.

The same randomness is at work in the financial markets. Portfolio managers design rules to generate alpha (the excess returns that a portfolio generates over an appropriate benchmark index).

Because of the inherent randomness in the market, these rules sometimes work, and sometimes do not.

Why it matters?

World Cup 2018 has shown that the quality between the stronger and the not-so-good football teams is narrowing. How else can you explain the performance of, say, Iran and Japan against stronger opponents during this World Cup? It is the same with portfolio managers. Why? For one, the cost of high-level computing has declined.

It is, therefore, relatively easy for investment professionals to create alpha strategies. But as all of them engage in similar processes, no strategy remains unique for a long time. Also, with professionals exploiting mis-priced securities from the same investment universe, returns differential between the top-performing funds and the not-so-good funds is likely to narrow.

Then, there are factors beyond a portfolio manager’s control. Just like how a bad decision by a referee can have an adverse impact on a team’s success, so can a change in tax law or other regulation have an adverse impact on the market and, therefore, on investment performance.

The upshot? Even skilful managers need a large dose of luck to consistently generate alpha.

The writer is the founder of Navera Consulting. Send your feedback to portfolioideas@thehindu.co.in

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