Why active investing doesn’t work

“But a respect for evidence compels me to incline towards the hypothesis that most portfolio decision makers should go out of business - take up plumbing, teach Greek, or help produce the annual GNP by services as corporate executives (sic). Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed. Few people will commit suicide without a push.” —Paul Samuelson

Stay away from fund managers who believe in active investing, or so Samuelson, the first winner of the Nobel Prize in Economics, seems to be suggesting in that quote, perhaps favouring investment in index funds. And what makes him do that?

Peter L Bernstein may have an answer. “In 2004, Burton Malkiel of Princeton, and author of A Random Walk Down Wall Street, studied all mutual funds in existence since 1970 - a total of 139 funds surviving over more than thirty years. He found that seventy six of the funds underperformed the market by more than one percentage point a year; only four funds outperformed by more than two percentage points a year.

Malkiel reports that more than 80 percent of the actively managed large capitalisation funds covered in the Lipper Analytical Services failed to match the returns of S&P 500 over periods of longer than ten years ending in 2003. Malkiel also points out that “there’s almost no persistence in excess performance……In decade after decade, the top funds in one period are often the bottom funds in the next… There’s no way to tell in advance which funds will outperform,”” Bernstein writes in Capital Ideas Evolving.

To cut a long story short, there is very little evidence that active investing works. Even if a fund manager has delivered better returns than the market, over a period of time, how does an investor identify him in advance? “If identification of superior managers becomes a simple matter for investors in general, those mangers will be buried under an avalanche of new money to a point where they will no longer be able to pursue the investment strategies that delivered the superior performance. There is a tipping point somewhere for every manager, regardless of skill and style,” writes Bernstein.

“The long history of mutual funds shows that superior performance, even in the short run, tends to attract new assets that swell the size of the portfolio under management. As assets under management increase, the costs of trading tend to follow suit, and the edge of the active manager begins to diminish.”

The primary reason why fund managers find it difficult to beat the returns of the market is that stock prices are so tough to predict. As Bernstein writes, “It is a paradox, but nevertheless true that stock prices are so hard to predict because stock prices are themselves predictions of the future.”

The other reason that makes active management of money difficult, is volatility. “Volatility - a fancy word for what happens when we are taken by surprise - is a vivid indicator of how ignorant of the future we are and how emotionally we respond when the future arrives and fails to conform to our expectations,” writes Bernstein.

Bernstein takes the help of Robert Shiller to take the point forward. “As Shiller interprets it, volatility means people are changing their minds about the future almost from moment to moment. And why? New information arrives that is different from what they had been expecting.

But, there is no need to believe that the new information is necessarily correct information or readily understandable information, or even the kind of information people should be heeding. In Shiller’s opinion, the so-called information on which investors base their decisions is a jumble of many factors that go beyond the cold facts of the economic fundamentals or the latest corporate earnings reports.”

“To Shiller, excess volatility implies “that changes occur for no fundamental reason at all.” The swings in stock prices seem to reflect investors’ attention to many factors other than the present value of future stream of dividend payments: fads and fashions, fears and hopes, rumor and restlessness, recent stock price performance, or old saws about how in the long run everything comes out rosy in the stock market”, writes Bernstein.

And since the herd likes to think in a similar way the asset pricing decisions are almost always wrong. As Bernstein writes “ When many investors are using the same kind of rules of thumb and arrive at similar kinds of beliefs about the future, asset prices are almost always wrong in the sense that the return investors anticipate is chronically too high or too low relative to the risks involved.”

In the world of active investment, almost everyone is trying to throw darts in the dark. “When you know only a little, and you know you know only a little, it is tempting to believe others may know more, especially when markets are moving strongly in one direction or another”, writes Bernstein.

Given this, luck starts playing a very important part. As Bernstein writes, “As a matter of luck, any portfolio manager can end up beating the market in short periods of time. Luck puts other managers below the market for short periods of time.” Hence, very few active managers like Warren Buffett, Bill Miller and Peter Lynch have been able to beat the markets, year-on-year, over a long period.