In our last blog, "Ignoring the Siren Song of Daily Market Pricing," we examined how price- setting occurs in capital markets, and why investors should avoid reacting to breaking news. Now let's look at why using a professional "pinch hitter" to try to beat the market is also ill-advised. In the words of Morningstar strategist Samuel Lee, managers who have persistently outperformed their benchmarks are "rarer than rare."
As we explained in "Jelly Beans and Investing Wisdom," independently thinking groups (such as capital markets) are better at arriving at accurate answers than even the smartest individuals in the group. Thus, even experts in analyzing business, economic, geopolitical or any other market-related information face the same challenges you do in predicting market behavior. For these experts, beating the collective group intelligence remains a prohibitively tall hurdle, especially when their fees are factored in.
But maybe you know of an extraordinary stockbroker, fund manager or TV personality who strikes you as being among the elite few who can make the leap. Maybe they have a stellar track record, impeccable credentials, a secret sauce or brand-name recognition. Should you turn to them for the latest market tips or should you pursue a strategy of capturing market returns with the least amount of risk, cost and tax?
Unfortunately, there is little credible evidence that hiring a stock picker/market timer is a good idea. In fact, the evidence to the contrary is overwhelming. Star fund managers often fail to survive, let alone persistently beat appropriate benchmarks. A 2013 Vanguard Group analysis found that only about half of some 1,500 actively managed funds available in 1998 still existed by the end of 2012, and only 18% of the survivors outperformed their benchmarks. Dimensional Fund Advisors found similar results in its independent analysis of 10-year mutual fund performance through year-end 2013.
Across the decades and around the world, a multitude of academic studies have scrutinized active manager performance and consistently found it lacking. Among the earliest such studies is Michael Jensen's 1967 paper, "The Performance of Mutual Funds in the Period 1945–1964." He concluded that there was "very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance."
A more recent landmark study is Eugene Fama's and Kenneth French's "Luck Versus Skill in the Cross Section of Mutual Fund Returns," from 2009. Fama and French demonstrated that "the high costs of active management show up intact as lower returns to investors."
In the decades between those two studies, as 100 similar studies, published by a who's-who of academic luminaries, have echoed the findings of Jensen, Fama and French. In 2011, the Netherlands
Authority for the Financial Markets (AFM) scrutinized this body of research and concluded: "Selecting active funds in advance that will achieve outperformance after deduction of costs is ... exceptionally difficult."
Can hedge fund managers and similar experts fare better than mutual fund managers? The evidence suggests not. For example, a March 2014 Barron's column took a look at hedge fund survivorship. The author reported that nearly 10% of hedge funds existing at the beginning of 2013 had closed by year-end, and nearly half of the hedge funds available five years prior were no longer available (presumably due to poor performance).
So far, we've been assessing some of the reasons it's hard to "beat" the market. The good news is that there is a simple way to let the market do what it does best on your behalf. In our next few blogs, we'll begin to explain how.