The Quest for Market Beating Performance
The holy grail
Much like the search for the fountain of youth, the quest for consistent market outperformance is a graveyard littered with failure. The reality is that the majority of actively managed funds, hedge funds, private equity, endowment funds and individual investors have failed to outperform a stock market index after fees.
Larry Swedroe, chief research officer at Buckingham Strategic Wealth wrote a fascinating book called ‘The Quest for Alpha’. It details his search for the holy grail of consistent market outperformance, beyond what can be normally expected by chance. He examines the evidence from numerous academic studies on mutual funds, hedge funds, pension plans, private equity, venture capital and individual investors. His verdict: that consistent market outperformance is just a myth.
It’s a sobering reality, my own investment journey 10 years ago started out in high risk penny shares, before migrating to stable blue-chips, then actively managed funds and now an increasing portion of my wealth is allocated towards index funds. Morningstar’s active Vs passive barometer and the S&P indices Vs Active scorecard (SPIVA), published semi-annually have certainly had a big influence on my growing reticence to stock selection.
Why selecting stocks is hard
The primary reason for this is the stock market phenomena that returns are enormously skewed, which means that a tiny number of stocks generate the lion’s share of returns, trying to identify these stocks in advance is akin it to finding a needle in a haystack. In a study by Hendrik Bessembinder ‘Do Global Stocks Outperform US Treasury Bills?’ — Which examines the performance of more than 60,000 global stocks between 1990 and 2018 — shows that most stocks are duds. The study revealed that the majority of US stocks and non-US stocks underperformed one month treasury bills. Studies by the likes of Vanguard have produced similar results, and it’s a powerful case for owning the haystack (an index fund).
Is there any way of identifying the winning companies or funds of tomorrow? There isn’t. At the beginning of the 20th century, the up and coming sector was auto manufacturers. Out of 100’s of now defunct automobiles companies, only a handful survived (Ford and General Motors), the chances of picking these are very slim.
Furthermore, in terms of picking actively managed funds, past performance has proven to be no prologue to future returns, and should you be fortunate to select a top performing fund, few have managed to sustain it. The reasons for this are numerous, first is that successful funds have become too big to manage, leading to liquidity constraints that raises trading costs and shrinks the universe of investable stocks. Other factors can be that a particular ‘style’ of investing which helped a manager deliver outperformance for a period of time simply stops working. Today the market is highly efficient, should a fund manager find an anomaly or style that delivers outperformance, it won’t be long before it is exploited away — therefore after fees their returns will start to lag the benchmark index.
Active investing is becoming harder
To make matters worse, there have been enormous changes taking place within the last few decades which has made the task of outperforming the market increasingly more difficult.
Charlie Ellis, American investment consultant and author of numerous books such as ‘The Index Revolution’ explains this shift:
“There’s been a change in place for 50 plus years or more of brilliantly talented, hard working, very well educated people coming into the investment management business. When I first came to the world of investment management in the mid 1960’s, there were no CFA’s now there are more than 100,000 CFA’s and more than 200,000 studying for their exams. There were no Bloomberg machines now there are more than 300,000 Bloomberg machines. They have unbelievably access to information, and their really good at what they do, and the problem is there are so many of them, and after fees they can’t possibly keep up with the market.”
In the US, 90% of stocks were in the hands of individuals in 1952 (according to the Federal Reserve), today the majority of money is held and managed by institutions, investment is now an industry. The market is now an aggregation of these highly informed, institutional investors with the latest information at their fingertips. Inefficiencies and anomalies that were once many are becoming harder to find.
Vicious circle
The rise in the number of skilled investors has the effect of increasing the efficiency of the overall stock market, making it harder to beat it. The heightened difficulty leads to poor market performance, prompting many investors to place their money into a simple index fund; this squeezes out the less skilled investors. The remaining fund managers will be lot more talented and tougher to beat. The cycle continues as more active investors drop out leaving a smaller number of immensely gifted fund managers, competing against each other.
With legions of highly intelligent investors, armed with the latest academic research and the best equipment — you have to ask yourself, what is your advantage? And what do you know about a company that isn’t already factored into the share price. It seems that sharing in the collective wisdom of the crowd through an index fund is the appropriate option for most investors. However conventional wisdom has it that the rise in passive investing will cause the market to become more inefficient, providing active investors with ample opportunities to outperform — only time will tell as to which scenario plays out.
As an investor you must ask yourself: Are you smarter than the collective wisdom of the investment crowd, I doubt it.
