Three Reasons Why Active Managers Will Continue To Underperform

Active managers, those trying to beat the market, are having one of their worst years in decades.  The data through mid-December is another nail in the coffin for the active management camp with 88% underperforming the S&P 500.  The data is pretty daming:

mutual funds

With only 12% of active managers beating their benchmark, it certainly begs the question of why and whether it will persist.  The why is very difficult to say.  Maybe it was the drop in oil, poor market timing or too bearish or bullish stances at the wrong time.  Whatever the reason, the majority of active managers have been wrong this year.  In addition, fees continue to be a major hurdle for professional managers to overcome in order to match a cost-free benchmark.  The more important question is whether this will persist.  Here are three reasons why it will:

  1. It's a mathematical fact- if all managers comprise the market, then pure math tells you that all can't outperform.  Someone buying the next best stock has to have a corresponding seller.  Without fees you could conclude that results would tend to be about 50/50 outperformers vs. underperformers.
  2. Fees- fees just make it harder for managers to outperform because of the hurdle they have to overcome.  Not only are there the expenses to the managers, but active managers have other expenses like commissions to buy/sell securities and bid-ask spreads that need to be factored in.
  3. The market is fiercely competitive- the idea that one person can determine if a security is under or over valued is flawed.  Think of the logic behind it.  There are literally millions of investors buying and selling securities every day at a specific price.  When you state you have a price target or that the security is mispriced for some reason, what you are really saying is that you know more than the collective group of investors who are setting the price.  We ran our own jelly bean experiment showing how futile this idea really is.

The results are pretty conclusive.  S&P runs a study twice a year showing that over 5 year periods, the majority of funds in all categories underperform their benchmark.  The idea that you or your advisor are going to select the best funds moving forward is naive at best.  Stick with controlling what is under your control:  diversification, discipline, fees and taxes.

Prediction Time!

It's that time of year again…prediction time.  Economists, wall street strategists and pundits have started coming out of the woodwork telling you where to put your money in 2015.  One thing they won't tell you is their track record from last year (unless it was good). One of the overwhelming areas that wall street hated last year at this time were bonds.  In a poll done by Bloomberg about a year ago, 72 out of 72 economists predicted interest rates to rise and bond values to fall.  72 out of 72!  With that amount of conviction, they have to be right.  Blackrock did something similar with all the major investment/research firms.  Again, everyone was underweight bonds.  Click below to see the graphic from their report:

consensus

You can guess what happened next.  World stocks (MSCI ACWI) were up 6.72% through 11/30 while long-term treasury bonds (Barclays Treasury Bond Index Long), the asset class that would have gotten hit hardest if these pundits were right, were up 21.59% for the same period.  Predictions may be fun to watch, but you should never make investment decisions based on them.  This is just more evidence that no one knows the future.  

Does International Investing Still Add Value?

For those of you keeping score, the US stock market has been trouncing its foreign brethern for the last 5 years.  The S&P 500 has generated a return of 15.96% for the 5 years ending on 11/30/2014.  Conversely, the MSCI EAFE and MSCI Emerging Market Indices have returned a meager 6.38% and 3.88%, respectively.  To put it another way $1 million invested in each of these three markets would have produced the following results:

  • US (S&P 500)- $2.22 million
  • International (MSCI EAFE)- $1.39 million
  • Emerging Markets (MSCI EM)- $1.26 million

While all have been positive, the US is the clear winner and these results are causing some to question whether international diversification is really necessary.  The argument is typically something along the lines of US companies sell globally now, so does it really matter where a company is domiciled.  I think it is a fair statement and one that is worth exploring in more depth.  Because of that we went back for the past 44 years to see if this is a common occurance or one we should be concerned about.  Here are the results (click on image):

Stock markets

The highlighted cells show the years where each market was the best performer.  At first glance what you see is that each market has had its day in the sun and there doesn't seem to be any rhyme or reason for which market is going to outperform.  In fact, over the past 44 years the US stock market and Emerging markets have both outperformed 16 of those years, while the International stock market has outperformed 12 of those years.  In addition, there was a time from around 2001 until 2007 where many were questioning whether investors should have exposure to US stocks, since Emerging Markets seemed to be the place to be.  Like always, that trend reversed and the pendulum has swung the opposite direction.  Instead of trying to guess which market is going to outperform in the future, we continue to stress that it is important to own some of each.  You'll always be happy (that you have the best performer in your portfolio) and upset (that you have the worst performer in your portfolio).  If you are interested in what that balance of US/International/Emerging Markets should be, please read our thoughts on the topic.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.