The evidence is clear, active investing offers a hollow promise of outperformance.
- Most active managers can’t beat the markets long term. It’s not because they’re lacking in intelligence—it’s because their costs are too high and they have too much portfolio turnover.
- Successful fund investing is about more than picking past winners. Consider a fund’s investment philosophy and trading costs.
- The market does a good job of pricing securities overall. This makes it difficult for managers to find mis-pricings, to time the markets or to outguess other investors.
The evidence is clear, professional investors who try to predict securities prices or market movements (active investing) have a dismal track record. A review of the Center for Research in Security Prices (University of Chicago) data as of 12/31/14 found that:
- Most active equity mutual funds underperform their benchmarks
- Funds with strong track records fail to persist in the future.
- High cost and high turnover contributes to underperformance of actively managed funds.
What lessons can be learned from these findings?
- The market does a good job of pricing securities, making it difficult for managers to outperform by outguessing other participants who are predicting market movements.
- Managers in search of mis-pricing opportunities face high cost barriers as they try to beat the market.
- Successful fund investing involves more than just this picking past winners.
- Consider a fund’s investment philosophy and trading costs.
Importantly, the failure of active management in mutual funds also applies to hedge funds.
The key lesson, however, is that capital markets work and that active management doesn’t. Active managers don’t fail to beat the markets because they are unintelligent—it’s because their cost structures are simply too high.
When we look back at the data 10 years from now, there will certainly be a handful of active managers who outperformed their benchmarks. The problem is that trying to identify them today, a decade before the numbers come in, is next to impossible. However, you can improve your investment experience and the probability of meeting your goals by making sure that your costs are controlled, and that your capital market exposures are consistent. Use the evidence about investing to your advantage.