In my last video, I talked about some of the challenges that active managers face in outperforming the market. It boils down to their relatively high fees, and intense competition from other managers.
There is another, less obvious reason that active managers have so much trouble beating the market. We know empirically that a small number of stocks in an index tend to drive the performance of that index. So trying to select stocks in an index dramatically increases the probability of underperforming. When trying to pick stocks in an index in an effort to beat the index, the likelihood of underperforming is much greater than the likelihood of outperforming.
If we look at data on market returns, the basis of this research is clear. Most of the market’s returns come from a small number of stocks. Let’s look at an example using data from global stock markets between 1994 and 2016.
Over that time period, global stocks returned an average of 7.3% per year. Not bad at all. If we remove the top 10% of stocks in that global market portfolio, the average annual return drops to 2.9%. Excluding the top 25% results in the average annual return dropping to a much less exciting -5.2%. Of course it would be great if active managers could identify only the top performing stocks, but we have seen the data around their ability to do so - it doesn’t look good.
We know that, in most cases, active managers’ performance can be attributed to luck rather than skill. A lucky manager has been fortunate to randomly select stocks that have done well. In their paper, Heaton, Polson, and Witte lay out a very simple example explaining the challenge that active managers face based on what we know about market returns.
If we have an index consisting of five stocks, and assume that four of them will return 10% and one will return 50% over a given time period, and we suppose that active managers will create portfolios using an equally weighted subset of either one or two of those stocks, there will be a set of fifteen possible actively managed portfolios. Ten of the fifteen portfolios will earn a 10% return due to omitting the 50% stock, and five of the fifteen portfolios will earn either a 30% return or a 50% return due to holding the 50% stock, depending on whether it is a one or two stock portfolio. In this example, the average return of the stocks in the index, and all active fund managers, will be 18% (before fees).
Just like we would expect, all active managers together get the return of the market. But when we look at each portfolio individually, two-thirds of the actively managed portfolios will underperform the index due to their not holding the 50% returning stock, which is always included in the index.
Closet indexing is the result of active managers owning the market like an index fund, but charging active management level fees. Some active managers will pitch themselves as having high conviction, or high active share, meaning that they are very different from the index. The implications of this research are that even if you are able to find an active manager that is truly active and has low fees, there is a relatively low probability that they will be able to deliver market beating performance. With this high probability of underperformance, finding a skilled manager, which we already know to be beyond challenging, becomes increasingly important.
Fees typically take the blame for the systematic underperformance of active managers, but this research demonstrates another big hurdle that needs to be overcome to beat the market. If active managers miss out on the relatively small proportion of top performing stocks, they are at significant risk of trailing the market.
In my next video, I will be talking about downside protection, one of the most prolific sales pitches in the investment management industry. Do index funds protect your downside? Join me to find out.
My name is Ben Felix of PWL Capital and this is Common Sense Investing. I’ll be talking about this and many other common sense investing topics in this series, so subscribe and click the bell for updates. I’d also love to hear from you as to what topics you’d like me to cover.
Original post at pwlcapital.com.