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The Myth of the Stock Market Guru

The reality is that luck and not skill explains outperformance by fund managers. When fund managers get lucky, the rewards are big, while investors who chase returns are driving Yugos. When will the madness stop?
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The securities industry has many ways to separate you from your money. My personal favorite is hedge funds.

These funds push all the right buttons: Greed, the promise of outsized returns, elitism, and the thrill of playing with the big boys. I'm sure you get the picture.

Back in October, 2009, Bloomberg did a fawning article on Paolo Pellegrini. It had a lot of ammunition.

Pellegrini has an engineering degree and a Harvard MBA. According to his field study advisor at Harvard, he was "into data and systems" and "...was intrigued by the potential of math-based systems to trade stocks." Sounds impressive, but not as much as his subsequent track record.

He helped Paulson & Co earn profits of more than $3.5 billion betting against subprime mortgages. Flush with victory, he formed his own private fund. He bet against U.S. Treasury futures, among other trades, and earned 52% from April 15, 2008-December, 2008.

It was now clear to everyone in the investment community that Pellegrini had the magic sauce insuring huge profits. It was clear to Pellegrini as well. In December, 2008, He started his own investment firm, PSQR Management LLC, and staked $100 million of his own money in it.

Investment "pros" extolled his virtues, noting his "rare ability to apply rigorous analysis to specific financial markets, as he did with the subprime trade." Bloomberg opined that his past performance was "no fluke" and noted that "Pellegrini's meteoric rise is proof that bad news can produce a lucrative bounty for those with the foresight to predict it."

So, are you in?

Fast forward to August 20, 2010. Pellegrini announced he is returning the money invested in his fund. The fund is down 11% this year. Last year it gained 62%. In July, it lost 7.9%. The losses were caused by bad bets against U.S. Treasury bonds, which have rallied since April.

To put these numbers in perspective, a globally diversified portfolio of index funds broke just about even year-to-date.

Pellegrini has a lot of company. According to a web site that tracks hedge funds, at least 117 funds have imploded since 2006. "Quant" funds have been hit particularly hard. These funds are run by "super brains" with Ph.Ds and quantitative skills enhanced by hyper fast computers. According to an article in the New York Times, assets in these funds are down 61% from 2007. Quant funds had a dismal performance record in 2008, which continued in 2009.

Maggie Ralbovsky, an officer of a firm that gives investment advice to big funds, is quoted as stating that "not all quants are created equal." She is right, but for the wrong reasons. Her observation implies there are superior quant managers out there, if only you could find them.

The reality is that luck and not skill explains outperformance by fund managers. Many studies conclusively demonstrate this fact. Neither Ms. Ralbovsky nor anyone else can help you find the next lucky quant fund manager.

When fund managers get lucky, the rewards are big. Pellegrini purchased what he called ""entry- level supercars": a silver Ferrari F430 with a base price of $168,000 and a black $109,000 Audi R8.

Investors who chase returns are driving Yugos.

When will the madness stop?

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Here is the trailer for my new book, Timeless Investment Advice.