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Active fund managers have had a good 12 months, but a terrible ten years
WHO wants mediocrity? That is what a lot of people say when the subject of
index-tracking, or passive fund management, comes up. They would rather choose
a fund manager (an active manager in the jargon) who tries to beat the market
by picking the best stocks. It does sound like a good idea.
The tricky bit is finding the right manager. The temptation is to look at past
performance but fund managers rarely beat the market for long.
The average fund manager is always going to struggle to beat the market (this
is a separate argument from whether markets are efficient ). That is because
the index reflects the performance of the average investor before costs. In a
world dominated by professional fund managers, there aren't enough amateurs for
the professionals to beat. Even the hedge funds, those supposed masters of the
universe , haven't been able to do it; Warren Buffett looks set to win a $1m
bet on the issue.
But the last 12 months have seen a revival of the fortunes of active managers
and there is talk that the cycle has turned. Individual stocks seem less
correlated with each other than during the 2010-2015 period; small stocks,
which aren't included in some indices, are doing well. In Britain, a very high
proportion of funds beat the market over the last year; US funds also seem to
have done so well.
The table, from S&P Dow Jones Indices, shows how many European-domiciled funds
(investing in a wide range of markets) have managed to beat the market over
one, three, five and 10 years. Eight out of 19 categories managed the feat over
one year, but that drops to four categories over three years, three over five
years and none over 10 years. In most categories over 10 years, you had a less
than one-in-five chance of finding a fund that beat the market.
So why do so many people think they can pick a winner? The answer may be found
in a new paper from James White, Jeff Rosenbluth and Victor Haghani of Elm
Partners that shows people find it very difficult to tell skill from luck.
Suppose you have two coins, one fair and the other biased 60% in favour of
heads. How many parallel tosses would you need to be 95% certain (statistically
speaking) of identifying the rigged coin? They asked 700 financial
professionals the question and their median guess was 40. The actual answer is
143. If you widen the experiment to three coins, the number rises to 220.
The authors then use a thought experiment, which assumes that 15% of fund
managers can generate a post-fee return of 1% a year relative to the market
while the other 85% lose 1%. They put 1% of the portfolio a year into each fund
and then shift more to the winners each year, based on the probability that
they can continue to outperform. Even after 10 years, the expected return on
this portfolio is -0.6% a year, relative to the index.
There is even more bad news. At least, a coin doesn t know whether the last
result was a head or a tail. Investment success is affected by past data; other
people copy a winning strategy and stocks can move from cheap to expensive as
they outperform. The authors add:
Sadly, the power of past returns to predict the future is even weaker in
investing than it is with coin flips. In the real world, any kind of
return-chasing strategy will face additional headwinds, amongst them the fact
that when an investment strategy was truly extraordinary in the past, its very
discovery will diminish future performance (or even make future returns
negative), as more capital is drawn towards it. This may be the prime reason
why investor returns (i.e. dollar-weighted returns) tend to be significantly
below fund returns (i.e. time-weighted returns). This doesn t happen with coin
flips.
To sum up, you may think you can pick a successful active manager. But the laws
of probability suggest you can t.