This article was originally published in the business section of The News Tribune Sunday October 2, 2016.
By Gary Brooks, CFP
When there were just hundreds of hedge funds, private equity funds and actively managed mutual funds, some of the investment managers with the right mix of skill and luck were able to stand out, producing impressive performance beyond that indicated by common index benchmarks.
Today, there are tens of thousands of hedge funds, private equity funds and actively managed mutual funds. Rather than a relatively small number of people trying to exploit mispricing of stocks and bonds in order to generate impressive returns, investment markets are now saturated with investors looking for an edge. And in many ways, it’s not just investors searching for that edge, it’s computers.
Advanced math, data processing power, machine learning and high-speed trading have given sophisticated investors new ways to operate in markets around the world. Markets aren’t competitive, they are hyper-competitive. New information about a company and its stocks or bonds is incorporated in markets in nanoseconds. Nobody legally and consistently has more information to profit from than others.
As more investors have built their skills and resources to evaluate and transact in markets, the available returns beyond benchmarks have diminished. Michael Mauboussin, an author and instructor on investing at Columbia Business School calls this the paradox of skill.
“Over the past 30 years, investing went from being dominated by individuals to dominated by institutions,” Mauboussin writes. “As investors have become more sophisticated and the dissemination of information has gotten cheaper and quicker over time, the variation in skill has narrowed and luck has become more important.”
SKILL OR LUCK?
Eugene Fama of the University of Chicago has researched market prices and performance for more than 50 years. He received the Nobel prize in economic sciences in 2013. I had an opportunity recently to join a small group of financial advisors to see him present his latest work. Among his many points about how to efficiently capture returns, he said, “You can never tell good active managers from bad because all outcomes are due to chance. In the good return population there are a lot of lucky guys and in the bad return population there are a lot of unlucky guys.”
Billions of dollars invested by individuals and institutions are overpaying and underachieving in investments where skill doesn’t pay like it once did and luck is a larger influence than ever. For most people, their investment participation comes through mutual funds – often a limited selection within an employer’s retirement plan. Paying higher fees to managers of these funds attempting to extract some edge is more frequently becoming a loser’s game.
TOUGH TO BEAT THE MARKET
Standard & Poor’s tracks mutual fund performance compared to benchmarks. Over all measured time periods, a majority of managed funds have underperformed. Over the 10 years ended June 30, this underperformance is striking. Among U.S. mutual funds, 85.36 percent of large-cap managers, 91.27 percent of mid-cap managers, and 90.75 percent of small-cap managers failed to outperform relevant benchmarks. The trend applies to international stocks and bond funds as well.
There are managers who outperform. They are among the small percentage that holds an edge over a period of time, but they do not hold that edge persistently. And often, in order to build an edge, they take more risk than their peers. This is exactly what can make them less likely to repeat the excess performance.
Add this to uninspiring results of hedge funds and private investments and it becomes clear why the largest institutional fund in the U.S. (California Public Employees Retirement) and the largest government fund in the world (Norway Government Pension) are moving away from high-cost actively managed investment strategies. For example, in its portfolio of 60 percent stocks, 40 percent in bonds, real estate and cash, the Norway sovereign fund owns a small piece of most of the publicly-traded stocks in the world, tilting its portfolio toward smaller companies and value stocks, for their higher expected returns over long periods.
SIMPLE MAY BE BETTER
A globally diversified, low-cost, tax-efficient investment portfolio that simply captures the market return can help more people achieve their goals with less risk of underperformance. This applies regardless of whether you are growth-oriented as you work toward retirement or focused on sustainable financial security when you’re no longer contributing to your savings in retirement.
The conventional approach — choosing from actively managed mutual funds, influenced by media touting “best of” lists — has demonstrated little evidence that it is worthwhile. You don’t have to pick the right investments or move in and out of them only at the right time in order to have a positive investment experience. Buy the global market and let it work for you.
Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Gig Harbor. Reach him at email@example.com.
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