Many of us at Greenspring used to be in the stock picking game. It was really hard. While our experience may have been anecdotal, there is new evidence coming out to support the idea that stock picking is a low probability strategy. The Value Walk blog has posted a very interesting study on this topic. Here are some of the major findings:
- Since 1983, the US stock market has consisted of 8,054 publicly traded stocks (including delisted stocks)
- 39% of stocks since 1983 have lost money
- 64% of stocks underperformed the Russell 3000 during their lifetime
- 18.5% of stocks lost at least 75% of their value over their lifetime
If you are keeping track at home, that means that you have a 1 in 3 chance to pick a stock that outperforms the index. When I first read these statistics, I was astonished. I figured that it should be about a 50/50 chance, since half the stocks should outperform and half should underperform. The data tells us something different. What we find is there is a very small contingent of stocks that have HUGE returns, while nearly 2/3rds failed to keep pace with the index. To put it another way, index returns are significantly influenced by just a small group of winners. If you don't happen to have some of these winners in your portfolio, you have a high probability of underperforming. Here is a really interesting chart:
The chart shows that only about 6% of all the stocks significantly outpace the index, but they have a huge influence on the overall returns of the index. What is the chance that you will be able to pick one or more of the stocks? In looking at it from an attribution standpoint, it is even more astonishing. 25% of the stocks in the US over the past 30+ years have accounted for ALL of the gains!
When you start to understand the math and statistics behind stock picking, it should become increasingly clear that owning the entire market is a much safer and prudent strategy than trying to concentrate your bets.
When you read or listen to investment analysts, you will often hear that certain periods are "stock pickers markets". The argument is that when the market is flat or declining you want a manager that can navigate the landscape, stay on the sidelines, or get more defensive when necessary. I always get a chuckle when I read these articles. The Wall Street Journal has an entire article talking to experts about when active management makes sense. The answer to this question could be answered by a student in middle school with basic math skills. Active investment management will always underperform their passive counterparts.
Nobel Prize winner Bill Sharpe, in his paper "The Arithmetic of Active Management" wrote the following:
Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principal are guilty of improper measurement.
Let me try to put it more simply. If we assume that the entire market consists of all the active and passive managers, then trading is a zero sum game. If I buy GE in my portfolio and it goes up (making me the winner), some other manager had to have sold me that stock (making them the loser). The totality of all the money managers will be the same return of the market BEFORE FEES. And there's the catch. Active managers charge higher fees than their passive counterpart, meaning that over ANY time period, active managers, as a whole, will underperform passive managers by the amount of their fees. Again, the math tells us this is true over any time period: 1 day, 1 year or 20 years.
Now, what I am not saying is that ALL active managers will underperform. I am just making the true statement that the average of all active managers will have to underperform. Random chance tells us that some will outperform and some will underperform. I'll leave the question of whether you can know who will outperform in advance to another post.
If you read this blog regularly, you know that we advocate a passive, low-cost, diversified investment portfolio. Most people equate that to index funds. For the majority of investors, index funds are a great alternative to their actively managed counterparts. But not everything about index funds is perfect. About 10 years ago we started to hear about some of the "front-running" that happens with index funds. Bloomberg has an article out called: The Hugely Profitable, Wholly Legal Way to Game the Stock Market:
When an index reconstitutes, it removes a group of stocks and adds another group. If you are a hedge fund or trader and you can guess in advance which stocks they will be, you can buy (or sell) them in advance of billions of dollars moving into (or out of) these specific securities. This is one of the reasons we choose to use a passive alternative to index funds. Here is another excerpt depicting a real-life example:
Don't get me wrong. Index funds, when compared to actively managed funds, get you 80% of the way there. The other 20% are some of the fringe activities that can be done to improve returns- developing a patient trading strategy, overweighting known risk premiums like small and value stocks, and other small moves like securities lending and not being a slave to tracking error. Improving portfolios, one small step at a time by the factors presented above, can have substantial positive impact on portfolio returns.
An article caught my eye today when a somewhat obsure mutual fund was singled out in the headline "#1 Ranked Fund Manager Beats S&P 500 For 40 Years". That is certainly an impressive track record and one to be proud of. The article's hero, 84 year old Albert Nicholas, was suprisingly humble in his comments, as he could have easily taken a victory lap after such an accomplishment:
“Some guys who are smarter than I am say we can’t outperform like this,” says Nicholas, who turned 84 in January. “But we have done it, so I will leave it at that.”
We often talk about how difficult it is to outperform the market. This is seemingly evidence against our claim. Well, maybe not.
First, it is important to remember that a group of managers will always beat the market. Random chance would suggest that some percent of the universe of funds will outperform. Unfortunately, it doesn't mean it is skill that is causing this outperformance. In this case I think something else is going on. We have often spoken about the small cap effect. The idea that small company stocks have beaten large company stocks over time. As I looked a little bit more deeply at the fund, I saw that Morningstar has categorized this fund as a mid-cap stock fund. So is it really an apples-to-apples comparison to benchmark it against a large cap index like the S&P 500?
Let's take a look at a more relevant benchmark, starting in July 1969, the funds inception (through 3/31/2015).
The Nicholas Fund 11.78%
CRSP 3-5 Index 11.95%
The CRSP or "Center for Research on Security Prices" splits the market up into ten deciles, 1 being the largest market cap companies, 10 being the smallest. The CRSP 3-5 is the entire market segmented between the 30th and 50th percentile sized companies (which CRSP considers "mid-cap"). As you can see, when we run an apple-to-apples comparison on the fund and benchmark, we find that the supposed #1 fund manager fails to outperform a relevant benchmark.
This is another example of why investors need to be careful of the financial media. I am not saying that this publication purposefully duped its readers, but their job is not to advise clients. It is to gain readership. Which of the articles would you be more compelled to click on?
- #1 Ranked Fund Manager Beats S&P 500 For 40 Years
- Another Mutual Fund Fails To Outperform Its Benchmark
All is not what it seems. We continue to encourage investors to focus on evidence when making decisions. And in this case the evidence continues to point towards the difficulty of active management.
Seven years ago Warren Buffet threw down the gauntlet. He bet any hedge fund that a simple Vanguard S&P 500 index fund would outperform the fund(s) of their choosing over a 10 year period. The wager? One million dollars would go to the winner's charity of choice. Each put up half the money of the bet. So where do things stand now, with only three years left on the bet? Buffet is way ahead. Fortune writer and Buffet biographer Carol Loomis sums it up:
Under the terms of the wager, Buffett is betting (with his own money, not Berkshire’s) on the stock market performance of an S&P 500 index fund while Protégé Partners, a New York money manager, is banking on five funds of hedge funds (the names of which have never been publicly disclosed) that Protégé carefully picked at the outset. Through the seven years, Vanguard’s 500 index fund, as represented by its Admiral shares, is up 63.5%. That’s the portfolio carrying Buffett’s colors. Protégé’s five hedge funds of funds are, on the average—the marker the bet uses—up an estimated 19.6%. (The “estimated” takes into account that not all of the five funds have final figures for 2014).
What's interesting about the bet is that it started in 2008. Buffet was way behind from the onset since the S&P 500 lost 37% in that first year. And there lies the genius behind Buffet's bet. He knew that by making the bet a 10 year horizon, the odds were massively in his favor. Why?
- Equity markets lose value about one of every three years, but when you go out to 10 years, they have a greater than 80% chance of gaining more than 5% and a greater than 50% chance of making more than 10%. Buffet knew that time was his friend.
- Fees for the hedge funds would eat into returns- when you are paying management fees, performance fees and heavy trading fees the hurdle rate to keep up with the market can be difficult to overcome. While anything can happen in one year, Buffet knew that if given enough time, the fees would prove to be their undoing.
There are many lessons that can be learned from this bet. Probably the biggest one is that if you ever have the opportunity to wager $1 million with the greatest investor of all-time, you should probably pass.
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.