We believe that it is sensible to make decisions based on evidence rather than feelings or intuition. Practically this means applying the available body of peer-reviewed academic research to making smarter financial decisions.
The Academic Research
Market participants compete with each other to profit by being the first to bring new information to the market. Not all knowledge can be given to everyone in its totality, so each individual has some advantage over others through their possession of unique information. The amazing thing about financial markets is that they are able to aggregate all information into a single metric: the price.
In his 1970 paper, Efficient Capital Markets: A Review of Theory and Empirical Work, Eugene F. Fama proposed the Efficient Market Hypothesis (EMH). An efficient market is a market where prices always fully reflect available information. Fama did not propose that markets are perfectly efficient. He proposed market efficiency as an ideal state that real markets can only approach.
Even if markets are not always perfectly efficient, the combination of competition and disperse information makes market prices reflect information without allowing anyone to interact with the price directly. This makes it extremely unlikely that any market participant, no matter how well-informed or knowledgeable, is able to consistently earn abnormal profits by being the first to bring information to the market. It is impossible to know in advance which individual pieces of information are going to be relevant for driving prices to their fundamental value.
While EMH cannot be proven, the inability of market participants to produce consistent excess risk-adjusted profits has been well documented. In Mark Carhartt’s 1997 paper, On Persistence in Mutual Fund Performance, he demonstrated that common characteristics of stocks (size, relative price, momentum) almost completely explain persistence in mutual fund performance. In their 2009 paper, Luck Versus Skill in the Cross Section of Mutual Fund Returns, Eugene F. Fama and Kenneth R. French showed that few mutual funds produce risk-adjusted returns sufficient to cover their costs.
Active Funds Underperform
Based on the academic research, we would expect actively managed funds to underperform their benchmark, on average. The performance data for actively managed funds delivers on this expectation. The SPIVA Canada Scorecard tracks the performance of Canadian actively managed mutual funds relative to their benchmark. The data show consistent underperformance across all fund categories.
Percent of Active Funds Outperforming the Index Over Five Years
The bad news for investors is that despite the underperformance of actively managed mutual funds, many financial advisors rely on the commissions that they pay.
If it is not possible for funds to beat the market consistently, why does it always seem like a financial advisor is able to show off funds with market-beating performance? The answer is survivorship bias. When a fund does poorly for an extended period of time, it closes. A closed fund's performance history disappears with it. The funds that do well, purely by chance, will be promoted by the fund company as a great investment. This is problematic for investors hoping to make informed decisions; there is no evidence that strong past performance has anything to do with future performance. In fact, there have been many funds that build up great track records over a period of time only to suffer horrendous future performance.
A Sensible Approach
Without the ability to beat the market through security selection or market timing, the most sensible approach to investing for most people is owning a globally diversified portfolio of low-cost index funds. An index fund is a fund that passively invests in all of the stocks in an index. An index is a grouping of stocks that has been assembled to represent a market. For example, the S&P/TSX Capped Composite index represents the Canadian market, and the S&P 500 index represents the US market. For all of their simplicity, index funds have fees that are a fraction of a traditional actively managed mutual fund.