Miller's Fall Shows Luck at Play in Investing

During famed fund manager Bill Miller's 15-year streak of outperforming the S&P 500, he was often held up as proof that stock picking wasn't just dumb luck. It required skill.

But the streak ended in 2006 and Miller became a poster boy for the other side of the debate over the ensuing years, as miserable performance brought his once stellar record back to earth.

As Legg Mason Inc announced on Thursday Miller was stepping down from his flagship Value Trust Fund, the debate is only likely to grow more heated.

At issue is perhaps the most critical decision for investors and their advisers who must choose every day between supposedly skilled active managers and lower cost, passive index funds.

A lot of this can be luck, said Don Phillips, president of fund research at Morningstar Inc. Even Miller himself always acknowledged what a difficult competitor the S&P 500 is, Phillips said. Even when he was getting all the praise, he was very skeptical.

Lately, the indexers have gained the upper hand. Investors withdrew $132 billion from actively managed equity funds over the 36 months ended Sept 30, according to Lipper, and added $351 billion to passive equity funds in the same period.

That's thanks in part to a growing body of academic research arguing that investment performance is mainly about luck.

According to these researchers, Miller's stock picking efforts were -- on the whole -- futile. And the nearly $100 billion that investors pay active fund managers in fees every year could be a waste of money.

Most of the annual variation in performance is due to luck, not skill, California Institute of Technology professor Bradford Cornell wrote in one typical recent study. Annual rankings of fund performance provide almost no information regarding management skill, Cornell noted in his 2008 analysis of the results of more than 1,000 equity mutual funds.

Most of the difference in performance resulted from random noise, he concluded.

Security returns are so variable, that if there is skill, it's very hard to tease it out, Cornell said in a recent interview.

Still, there is a deeply human impulse to try to beat the markets. University of Maryland professor Russ Wermers' own research showed it was almost impossible to pick talented investment managers out of the crowd. Nonetheless, he invested some of his own retirement money with Miller.

Beating the S&P 500 15 years straight, even though the last few may have been lucky, seems very unlikely to be luck alone, Wermers said.

SORTING OUT LUCK

Just where to balance the roles of skill and luck is a major debate in wealth management. No fund manager can predict the future with certainty and even some of the most successful say their research and analysis simply improve their odds of earning a profit.

Miller knows all of these arguments and knows that his own record of high highs and low lows provides fodder for all sides. Still, Miller said he believes skill matters, at least over the long run.

The shorter the time frame, the more likely it (success) is just likely due to chance, Miller said in an interview at his office late one afternoon in October, just before the start of an annual conference his firm holds on the intersection of science and investing.

Pressed, he said that only after about 10 years does skill start to play an equal role as luck in investing.

Miller has also argued that an investor may profit due to skill for a while but the skills may wane or become less relevant over time.

It's perfectly possible that somebody who is a money manager can be skillful in some domains and not in others or skillful at some time, he said later at the conference.

Tall and animated, Miller talked about investing with an enthusiasm that showed how it had become both his profession and hobby. He often takes securities filings to read while watching his beloved Baltimore Orioles.

END OF THE STREAK

Miller's amazing winning streak came to an end in 2006, just as Fortune Magazine had dubbed him the greatest money manager of our time.

The streak ended because all streaks eventually end, and because we made some mistakes, such as not being invested in energy in 2003 when it was cheap, in being too concentrated when concentration added no value, and due to some bad luck, Miller wrote to investors in January, 2007. Sometimes luck helps and sometimes it doesn't.

The next year, Value Trust dropped 7 percent, making it among the worst performing funds of its category, while the S&P gained 5 percent.

The worst hit came in 2008 when the fund fell 55 percent, much worse than the 37 percent S&P loss, after Miller stuck too long with failing financial companies like Bear Stearns and American International Group Inc.

Despite some ups and downs over the next few years, the fund only outperformed the S&P 500 Index one year -- 2009 -- since the streak ended.

MIT finance professor Andrew Lo, generally a critic of active stock picking, mentions Warren Buffett and George Soros as possible examples of skilled investors. But neither discloses enough details about their process to evaluate their methods fully, Lo said.

The finance industry may be no different than other fields in which a few stars distract attention from the mediocre majority.

There are a lot of movie actors out there, but not a lot of Brad Pitts and George Clooneys, Lo said.

Sam Peters, who will be taking over as lead manager of Miller's fund, said he shares much of Miller's philosophy when it comes to stock-picking.

When it comes to investing, luck still determines many outcomes as the skills of all investment managers improve, he said. But the fund's investment process will also be important.

Luck is a big deal, Peters said in an interview. Do I think luck is going to be my friend over the next 10 years? Absolutely!