Jeff Buckner, CFP®, AIF®, Co-Chief Investment Officer
In our first investment philosophy post we discussed the Efficient Market Hypothesis. The EMH leads us to embrace market pricing. Research shows that attempting to beat the market through stock picking is unwise, a gambler’s game rather than a skill to master. In this post we include a case study of mutual fund managers to reinforce this point, encouraging investors to avoid trying to outguess the market.
Tenet #2 - Don't Try to Outguess the Market:
If you’re convinced you have what it takes to beat the market, consider the track record of some of the best equipped traders in the market: active mutual fund managers. The efficient market hypothesis holds that the stock market’s pricing power works against mutual fund managers who try to outsmart other market participants through stock picking or market timing. Study after study has shown that after factoring in the expenses of running a fund, these managers are unable to consistently achieve market-beating returns.¹
A 2016 report by Dimensional Funds Advisors (DFA), studied the performance of 2,758 actively traded mutual funds from 2001-2015, tracking each manager's performance against the broader market.²
The chart below shows the results. After 15 years only 43% of the original funds had survived, with the majority being liquidated or merged with other funds during the 15 years. Even fewer funds could beat the market. Over the time period only 17% of US equity (stock) mutual funds outperformed their benchmarks. Fewer than one in five!
.jpg)
As you look at the chart remember these managers:
Have More Training than You: Mutual fund managers have spent a lifetime making a study of the market, reading company research reports, analyzing earnings statements, speaking to company representatives, and sleuthing out investment stories. On average, they still can’t outsmart the market.
Have More Time than You: While you likely spend most of your time employed elsewhere, making investment decisions is their full time job.
Have More Help than You: Unless you’re managing your own private equity fund, you likely don’t have a team of analysts to help you make your financial decisions. Fund managers do.
Have More to Win (and Lose!) than You: The stakes are high for mutual fund managers. A winning fund can make you a rock star among investors. Stringing together winning years can mean millions more in bonuses for the manager, tens of millions more invested into the fund, and greater career opportunities in the future. The converse is also true. As the chart above shows, each year hundreds of poorly performing funds are merged or liquidated. The managers that run them are moved back to the Minor Leagues.
If these fund managers with more training, time, resources, and incentives than you still can’t beat the market, what makes you think you can? Which brings us to our third tenet.
Tenet #3 - Resist Chasing Past Performance:
Some investors will have temporary success at beating the market. You may be thinking, “What about those 17% of managers who beat the market! I’ll just invest my money with them.” That would make a lot of sense if past performance could guarantee future results. But if you’ve read any investment disclaimer you know that just isn’t the case, “Past performance does not guarantee future results.” The research shows the same.
The issue is the persistence problem. Persistence is the ability of a successful manager to consistently outperform. Unfortunately, this is notoriously difficult to do. For instance, in the study cited above DFA broke out the results between fund managers over the 10 years from 2001 to 2010.³
They identified the top 20% performers (541 funds) in the ten year period and continued to study their performance for the following five years from 2011-2015. Did outperformance persist? Could they remain the cream of the crop?
The graph shows the proportion of US equity mutual funds that outperformed and underperformed their respective benchmarks (i.e., winners and losers) during the initial 10-year period ending December 31, 2010. Winning funds were re-evaluated in the subsequent five-year period from 2011 through 2015, with the graph showing winners (outperformers) and losers (underperformers).
Nope. As you can see from the chart above, fewer than half could stay on in the top-performing category. After five years only 37% of the top funds were still in the top 20% in performance.
Mutual fund managers may have the hot hand for a while, prompting opportunistic investors to pump money into the fund. But just like a lucky gambler in Vegas, eventually the hot hand gets cold, the house wins, and the crowd disperses to find the next lucky winner.
So what should an intelligent investor do? We think the evidence is clear. Don’t try to outguess the market. Resist chasing past performance. And as you’ll see in our next post, build wealth by letting the market work for you.
Next Post: Let the Market Work For You