When it comes to choosing an index-tracking, or passive fund management, investment a lot of people choose a manager who tries to beat the market by picking the best stocks, because that sounds like a great 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.
The table, from Standard & Poor’s, 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.
Read the complete article on The Economist web site.