Financial advice that starts with a plan.
We help you do more with what you’ve earned.
It is well-documented that the vast majority of investors, whether financial advisors, hedge fund managers, individual investors, or even day traders, underperform the market. This may or may not come as a surprise to you, but it fascinates me. An entire population of people devotes years of their life to a craft that yields no results. Welcome to the world of active management.
Active management is the practice of intentionally trying to beat the market. This occurs in all aspects of investment management, the stock market, the bond market, futures, options, etc. As with anything else in life, there is a trade-off for every decision that you make. If you want a promotion at work, you will have to work for it. Whether that is working extra hours, taking on additional responsibilities, or going back to school, the cost must come from somewhere. The same is true for an investment strategy. If you want abnormal returns, you will have to take on some form of risk. The more risk you accept, the higher the expected return. Is this truth universally applied? Yes, but there are exceptions. Sometimes (and infrequently), the perfect investment opportunity will come when an outsized gain is achieved with minimal risk. But these happen rarely.
Active Investing
Active portfolio managers are investors trying to outperform indices. They are constantly looking for opportunities where the expected return is greater than the assumed level of risk. The number of active investors seeking these opportunities has grown exponentially over the years, making it nearly impossible to find these rare gems. Thus, the markets have become very efficient, some more than others. This means that any time news breaks about a certain company or sector, the price of those assets immediately reflects that news.
For example, let’s assume that Apple, Inc. (AAPL) reports manufacturing trouble. The news would send the stock price down almost immediately, simply because Apple would now receive reduced future cash flows due to the manufacturing troubles. Because so many investors (and machines) are scanning the newswire for information like this, it is challenging to make a profitable trade in this scenario. The low-hanging fruit opportunities, at least here in the U.S., are extremely difficult to identify. Most managers fail to find them. As such, Bull Oak Capital advocates passive index investing for most asset classes, as most markets are efficient. However, there are some active managers who can add value.
Active Investing is Hard
Is it at least possible for you (or an active fund that you own) to beat the index? Of course, it is, but it depends on which market you are playing in, your access to key information, your skill, and your luck. There are plenty of famous investors who have made a career of picking stocks, such as Warren Buffett, John Templeton, Stanley Druckenmiller, Cathie Wood, and others. However, they are in the extreme minority. Most investors do not fare so well. According to a SPIVA (S&P Indices Versus Active) study, 84.2% of active managers here in the U.S. underperformed the large-cap index.
In other words, for every 50 active investors, only 7 beat the benchmark. For a more thorough look into the other asset classes here in the United States, please see below. The theme of underperformance persists.
International Markets A Little Better
If we look at international markets, we can clearly surmise that they are not nearly as efficient as the United States, meaning there is still opportunity for active managers to add value. However, picking an active manager that will outperform is still less than 50%, not great odds.
What About Past Performance?
Most investors look at a manager’s past performance when determining whether or not to invest. One of the most important measures is whether the manager can deliver above-average returns over multiple periods. However, outperforming over time has also proven to be difficult.
“An inverse relationship generally exists between the measurement time horizon and the ability of top-performing funds to maintain their status. It is worth noting that fewer than 1% of large-cap funds, and none of the mid-cap or small-cap funds, managed to remain in the top quartile at the end of the five-year measurement period. This figure paints a negative picture regarding the lack of long-term persistence in mutual fund returns.” (S&P Persistence)
Active Management Underperforms
As many of you know, Bull Oak Capital invests in passive index ETFs because of this data. The odds of outperformance at the sub-asset class level is low. Many managers will argue that they can exploit inefficiencies in the stock and bond markets and capture that value (alpha). Perhaps they can, but most cannot. For those who have, I have a few questions:
- Can you recreate your methodology to capture that value year-over-year consistently?
- How much of that outperformance (if any) is due to skill versus luck?
- Are you simply riding momentum, or are you style drifting?
The truth is that most individuals can’t tell whether or not a fund manager is skillful or lucky. Persistence is one important measure to test this, but not the only one. It is better not to play the game at all to keep your pocketbook and sanity levels high.
