The chart above is taken from the Investment Company Institute’s 2014 Factbook. Since 2000, the share of mutual fund assets invested in index funds has doubled. Why are more and more investors deciding to simply invest in market rather than trying to beat it? The short answer is because most investors fail to beat the market. Here are the facts:
- Most institutional fund managers underperform the market. The percentage of professional fund managers that underperform is significant; varying between 60 and 85% depending on the time period, data set (mutual fund or institutional) and market being analyzed.
- Most individuals also underperform the market because they often make buying and selling decisions based on emotion and they frequently over-trade.
- Performance is highly cyclical. This is just another way of saying that, what goes up, often comes down. This is why we always see a “past performance does not predict future performance” disclaimer on the marketing materials of most investment products.
- Even investors with excellent long-term returns will almost always experience several years of underperformance relative to the market.
- It is difficult to consistently pick in advance which investors will out-perform.
- It is very difficult to prove statistically whether or not an investor has skill.
- Assuming that you can find a professional fund manager with skill: management fees, brokerage, market impact costs and taxes are a drag on performance.
- Most investors – both retail and large institutional investors – invest in funds with strong historical out-performance and redeem from funds with poor historical performance.
Why would anyone – faced with these facts – try to argue that it’s possible to beat the market? Because facts alone aren’t enough, they need to be explained. On their own they don’t provide any answers, just more questions:
- Why do most institutional investors under-perform? Is it because they lack skill? Or are there other reasons?
- How concerned should we be about the cyclical performance of fund managers or of our own portfolio?
- Is there any way that we can stack the odds in our favour when selecting a fund manager, investment strategy or stocks for our portfolios?
- If we can’t rely on statistics, how might we tell if an investor has skill or if an investment strategy will work?
- Could our behaviour, and the behaviour of other investors like us, be part of the problem? If so, what can we do about it?
- What if we invest differently to most institutional investors, will we get different results? Can individual investors ever hope to beat institutional investors?
A popular explanation for the facts listed above is the efficient market hypothesis (EMH). An example of the logic behind the EMH can be found in Charles Ellis’ book Winning the Loser’s Game, 5th Edition: Timeless Strategies for Successful Investing. Here are some quotes from the book:
Unhappily, the basic assumption that most institutional investors can outperform the market is false. The institutions are the market. They cannot, as a group, outperform themselves. In fact, given the cost of active management … 85 percent of investment managers have and will continue over the long term to underperform the overall market.
The problem is not that investment research is not done well. The problem is that research is done very well by many… As a result, no single group of investors is likely to gain and sustain a repetitive useful advantage over all other investors on stock selection. Because they are so large, so well-informed, and so active, institutional investors set the prices. That’s why the only way to beat the market is to beat the professionals who, as a group, are the market.
Just how good and tough to beat are the hundred largest institutions? Here are some realities: The very largest institutions each pay Wall Street $1 billion annually and pay their leading stockbrokers as much as $100 million apiece, and the stockbrokers earn it by making the best markets and providing the best research services they can deliver. The institutions have Bloomberg and all the other sophisticated information devices. Their professionals meet with corporate management frequently. They all have teams of in-house analysts and senior portfolio managers with an average of 20 years of investing experience – all working their contacts and networks to get the best information all the time. You get the picture: Compared to any individual investor, the institution has all of the advantages.
To summarize Ellis, the market is full of professional investors that are highly-educated, more experienced and better resourced than the average investor. As a group, these professionals are constantly buying the stocks that they think that are cheap and selling the stocks that they think are expensive. The result of all of this buying and selling is that stock prices accurately reflect all of the market’s information about a company. In other words, trying to pick stocks is a waste of time.
This is both reasonable and logical. But it doesn’t work because it’s based on several assumptions that are unrealistic. Hopefully, this will become clear as we answer each of the questions listed above.
As we answer these questions, we will discover that the undeniable truths about the inability of most investors to beat the market can be explained simply (and not by the EMH). Not only that that, the answers provide clues on what we can do to beat the market. So without further ado, let’s get to the answers.
Q – Why do most institutional investors under-perform? Is it because they lack skill? Or is there another reason?
A – Fund managers do indeed have stock-picking skill. Unfortunately most fund managers invest in a way that systematically undermines their skill. They do this because of the principal and agent problem. The unsurprising result of this is that most managers underperform after fees and costs.
In their research paper Diversification versus Concentration… and the Winner is? Paolo Pellizzari, Ron Bird and Sazali Abidin used the holdings data of US equity mutual funds to create concentrated portfolios – ranging from 5-30 stocks.
Portfolios were constructed by comparing the holding size of each stock in the fund manager’s portfolio with the holding size of each stock in the benchmark. Stocks with the largest portfolio holding weights relative to the benchmark are considered to be the fund manager’s “best ideas”. The research found that:
… concentrated portfolios outperform both the actual performance of the fund and its benchmark. Risk-adjusted performance also tends to be higher for the more concentrated portfolios as compared to the actual portfolios and the benchmark.
These findings are basically good news for the professional managers who have long been criticised for their performance. The evidence suggests that they are actually good at what they spend most of their time doing, selecting stocks. The problem is that they are stripped of this edge due to having to depart from their stock preferences in the interests of diversification and risk control.
Why are most fund managers obliged to own stocks that subtract from the performance of their best ideas? They do this for several reasons:
- Liquidity – portfolios that are similar to the benchmark are easier to trade.
- Capacity – it allows them to gather more assets.
- Agency risk – It reduces the chances of getting fired for results that are wildly different to their benchmark or to their peers.
- Risk Measurement – Commonly used statistical measures such as tracking error and information ratio limit their flexibility to be truly different.
This leads us to the principal and agent problem. Wikipedia defines the principal and agent problem as:
… when one person or entity (the “agent”) is able to make decisions that impact, or on behalf of, another person or entity: the “principal”. The dilemma exists because sometimes the agent is motivated to act in his own best interests rather than those of the principal. The agent-principal relationship is a useful analytic tool in political science and economics, but may also apply to other areas.
The investor is the principal. As the principal, the investor acts only for themselves and is therefore free from any conflict of interest. Their goal might be to generate income, increase their wealth or a combination of both.
The problem is that the vast majority of investors don’t invest on their own behalf. They rely on one or more agents who have competing priorities: the responsibility to act in the best interests of their clients and the need to run a profitable business. These agents include intermediaries such as banks, custodians, stockbrokers, asset consultants, fund managers, regulators, accountants, financial advisors and pension funds.
It doesn’t take a genius to recognize that such a situation carries the potential for conflicts of interest. How can we identify potential conflicts of interest? By looking at incentives – particularly the way in which an agent gets paid for the work that they do. Here are just two examples (a similar table can be created for all the other agents listed above):
|Institutional Investors||Asset-based investment management fee||
The consequences of such conflicts of interest are neatly summed up by Charles Munger, Warren Buffet’s legendary right-hand man and a successful investor in his own right, who in a recent interview, summed up the absurdity of much of the money-management industry:
Back in 2000, venture-capital funds raised $100 billion and put it into Internet start-ups — $100 billion! They would have been better off taking at least $50 billion of it, putting it into bushel baskets and lighting it on fire with an acetylene torch. That’s the kind of madness you get with fee-driven investment management. Everyone wants to be an investment manager, raise the maximum amount of money, trade like mad with one another, and then just scrape the fees off the top. I know one guy, he’s extremely smart and a very capable investor. I asked him, ‘What returns do you tell your institutional clients you will earn for them?’ He said, ‘20%.’ I couldn’t believe it, because he knows that’s impossible. But he said, ‘Charlie, if I gave them a lower number, they wouldn’t give me any money to invest!’ The investment-management business is insane.
What of Ellis’ claim that institutional investment is full of the best and brightest minds meaning that average individuals can’t possibly hope to do better? There are two problems with this line of reasoning. The first is this: even if you select skilled and experienced investors how do you make sure that they are working for you? The results suggest that incentives and conflicts of interest prevent this from happening most of the time.
The second problem is this: institutional investment management is not immune from office politics. Anyone who’s ever worked in an office of any kind knows that reality is full of situations just like this Dilbert cartoon:
If you prefer a more formal description, here’s John Kenneth Galbraith from his book A Short History of Financial Euphoria:
Finally and more specifically, we compulsively associate unusual intelligence with the leadership of great financial institutions – the large banking, investment-banking, insurance, and brokerage houses. The larger the capital assets and income flow controlled, the deeper the presumed financial, economic and social perception.
In practice, the individual or individuals at the top of these institutions are often there because, as happens regularly in great organizations, theirs was mentally the most predictable and, in consequence, bureaucratically the least inimical of the contending talent. He, she, or they are then endowed with the authority that encourages acquiescence from their subordinates and applause from their acolytes and that excludes adverse opinion or criticism. They are thus admirably protected in what may be a serious commitment to error.
This is the mistake that Ellis, and all who believe that its impossible to beat the market, make – they give professional investors too much credit.
Believers in the EMH largely ignore effects of the principal and agent problem as Professor Paul Woolley from the London School of Economics explains in his excellent paper “Why are financial markets so inefficient and exploitative – and a suggested remedy”:
The crucial flaw has been to assume that prices are set by an army of private investors, or the “representative household” as the jargon has it. Households are assumed to invest directly in equities and bonds across the spectrum of the derivatives markets. Theory has ignored the real world complication that investors delegate virtually all their involvement in financial matters to professional intermediaries… who therefore dominate the pricing process.
Delegation creates an agency problem. Agents have access to more and better information than the investors who appoint them, and the interests and objectives of agents frequently differ from those of their principals. For their part, principals cannot be certain of the competence or diligence of the agents. Introducing agents brings greater realism to asset-pricing models and, more importantly, gives a far better understanding of how capital markets function.
Clearly most investors rely on agents to invest and most agents have conflicted interests. Should we then be surprised that most institutional investors underperform the market?
I would be remiss if I didn’t point out that I know many professionals investors that are honest, ethical and highly skilled – individuals that have earned my trust. It would also be very unfair of me to suggest that there are no “agents” out there that are doing the right thing by their clients.
So what point am I trying to make? That like any industry or profession, there are good operators and bad operators; with the added complication that it can be quite hard to tell the two apart when it comes to investing. Why is it harder? Every investment decision is subject to a degree of uncertainty and risk because nobody knows for sure what will happen in the future.
The practical application of my this post is that unless you can:
- do it yourself properly
- find agents that you trust
- incentivize them appropriately and fairly
- minimize potential conflicts of interest
you should consider using a low-cost, diversified, index fund.
This is not to say that index funds are perfect – far from it – they have several important flaws. However, you will probably end up with a better result – despite these flaws – when compared to investing with the “help” of a variety of agents that over-promise, over-charge and under-deliver.
If you remember only one thing from this post I hope that it is this: beating the market is possible, but only under the right circumstances!
My next opinion post will attempt to answer the second question: How concerned should we be about the cyclical performance of fund managers or of our own portfolio?
In the meantime, look out for an Opportunity? post on Metcash (MTS).
P.S. Here is a list of some of the references that I used in preparing this post.
- Cohen, Randolph B., Christopher Polk, and Berhard Silli. “Best Ideas.” Working Paper, 2010.
- Siegel, Laurence B. and Scanlan, Matthew H. “No Fear of Commitment: The Role of High-Conviction Active Management.” The Journal of Investing. 2014.
- Sebastian, Mike and Attaluri, Sudhakar. “Conviction in Equity investing.” Journal of Portfolio Management. Summer 2014.
- Greenblatt, Joel. “You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits.” Touchstone. 1999.
- Chambers, David. Dimson, Elroy and Foo, Justin. “Keynes the Stock Market Investor: A Quantitative Analysis.” Journal of Financial and Quantitative Analysis. Septmber 2013.
- Kay, John. “The Kay Review of UK Equity Markets and Long–Term Decision Making.” UK House of Commons. July 2012.
- Woolley, Paul. “Why are financial markets so inefficient and exploitative – and a suggested remedy.” The Future of Finance: The LSE Report 2010.