The conventional wisdom regarding evaluating the performance of an asset manager is wrong, according to a recent article in The Wall Street Journal.

Typically, the article points out, investors focus on a manager’s one, three and five-year trailing returns, the underlying assumption being that the better managers should outperform during these windows. However, it argues, “a manager’s realized return can be thought of as containing two components: skill and luck,” adding that, over one-, three- and five-year time periods, “it’s not uncommon for luck to overwhelm the impact of skill.”

The skill part of the equation, however, should be the focus. “The sober reality,” the article asserts, “is that a ‘good’ manager only has slightly better than 50/50 odds of outperforming over a three-year period.” Most of the return over that period, it says, is “driven by luck, whether good or bad.”

The implications for investors are as follows:

• “First, if finding and retaining a ‘good’ manager is the ultimate goal, investors need to be more patient, focusing on longer run manager performance.”
• “Second, assessing manager skill needs to go beyond just focusing on realized return performance.”