Want to get better at investing? Are you looking for simple, approachable ways to deepen your knowledge of the keys that create financial success? Using academic research and expert advice, this resource offers 12 principles for building wise, sustainable wealth.
Principle 4: If It Seems Too Good To Be True, It Is
Now that we’ve seen why investors should resist the impulse to react to breaking news, let’s look at why it’s a bad idea to seek a financial guru to compete for you. Morningstar strategist Samuel Lee sums it up nicely: it’s “rarer than rare” to find fund managers who have consistently outperformed their benchmarks.
Better Off with Group Intelligence
The truth is, even trained specialists who analyze business, economic or geopolitical information have the same problem that ordinary investors do when it comes to anticipating market reactions to current events. They’re no better at predicting the future than anyone else, and furthermore, they have to compete against group intelligence. As we discovered previously, capital markets (like the independently thinking groups in studies) are more skilled at determining correct answers than even the most intelligent people in the group, in part because their knowledge is already grouped into prices that adjust quickly and with relative accuracy to any unexpected events.
The Evidence on “Star Performers”
Perhaps you’ve heard of elite fund managers who have impeccable track records or brilliant stock brokers with exclusive formulas for investment success. Maybe you’ve seen TV personalities who seem to have a special edge. Investors who aren’t satisfied by their returns are often tempted to seek advice from these “exceptional” performers. But before doing so, it’s essential to look carefully at what really works.
If well-informed, careful investors were able to show higher returns based on advice given by star performers, there would be ample data to support it.
Unfortunately, there’s no such evidence showing higher returns; in fact, there’s an overwhelming body of evidence to the contrary. While some “active managers” fail to outperform comparable market returns, many do not survive at all. Only about half of some 1,500 actively managed funds available in 1998 still existed by the end of 2012, according to a 2013 Vanguard Group analysis.
A scant 18% of the surviving funds had outperformed their benchmarks. Other studies, such as Dimensional Fund Advisors’ independent analysis of 10-year mutual fund performance through year-end 2013 showed similar outcomes.
Past performance is no guarantee of future results. In US dollars. US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago. Beginning sample includes funds as of the beginning of the 15-year period ending in 2014. The number of funds as of the beginning is indicated below the exhibit. Survivors are funds that are still in existence as of December 31, 2014. Winners are funds that survive and beat their respective benchmarks over the period. Funds are identified using Lipper fund classification codes and are matched to their respective benchmarks at the beginning of the sample period. Loser funds are funds that did not survive the period or whose cumulative return did not exceed their respective benchmark.
Drawing from information gathered over the course of decades from markets around the world, a multitude of academic studies have analyzed active manager performance and consistently found that it comes up short. Michael Jensen made one of the earliest studies of this phenomenon in his 1967 paper, “The Performance of Mutual Funds in the Period 1945–1964.” There was, Jensen concluded, “very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.”
Eugene Fama and Kenneth French’s study from 2009, “Luck Versus Skill in the Cross Section of Mutual Fund Returns,” shows the same outcome. They discourage active management because it’s expensive and fails to deliver better results: “The high costs of active management show up intact as lower returns to investors.”
From the mid-20th century to the present, as many as 100 comparable studies uniformly agree with Jensen, Fama and French. “Selecting active funds in advance that will achieve outperformance after deduction of costs is […] exceptionally difficult,” was the conclusion reached by the Netherlands Authority for the Financial Markets (AFM) after it conducted an overview of all this data in 2011.
If managed funds often fail to meet expectations, investors often assume that hedge fund managers and similar experts might be more successful. Unfortunately, the evidence does not support that assumption either. Ten percent of hedge funds available at the beginning of 2013 had closed by the end of the same year. The statistics are far worse for long-term funds, with nearly half of the funds going belly-up within five years, according to a March 2014 Barron’s column on hedge fund survivorship.
The Bottom Line
Now that we’ve discussed a few common misconceptions about the value of active management, let’s look at positive steps you can take to make the market work for you. The first step is getting familiar with a strategy that’s been shown to succeed for investors: Diversification.
