Let's say you choose a fund which has performed very well in the last year. How do you figure out whether that outperformance was due to fund manager skill, which should be rewarded, or whether the fund managers were just lucky, which shouldn't be rewarded? Watch this video to find out!
As an investor you have two choices: either do it yourself, or hire a manager. If you fancy yourself as a Gordon Gecko, you can open a brokerage account, and set about selecting which shares and bonds to buy. In the second model you hand over your money to an expert, hopefully with a track record like the legendary Warren Buffett, and in return for skillful investment and good returns you pay that fund manager a fee.
You choose your fund, it's performed very well over the last year, is that outperformance relative to its peers due to luck or skill? Here are two hypothetical fund managers. Both have performed very well over the last year. The one on the left outperformed because of his deep and insightful analysis. The one on the right chose his investments randomly. His outperformance was simply because he was lucky.
Standard & Poors produce an incredibly useful report which they call "The Persistence Scorecard". They analyse 631 domestic US equity funds and they track the funds to see how consistent they are. This is the best way to figure out if outperformance is due to skill or luck. Their findings are quite shocking! From September 2014 only 3% of the top quarter performing funds were still in the top quarter in September 2016. If we lengthen the horizon over which we track the funds the story gets even worse.
Over a 5 year period only 1% of the large-cap funds and none of the mid-cap or small-cap funds stayed in the top quarter. This strongly suggests that it's luck, not skill, that drives outperformance in US mutual funds.
These facts are not new. But it's only recently that the message has started getting through. There is a revolutionary shift underway as investors lose faith in the ability of fund managers to outperform the market. Capital is being withdrawn from active funds and shifted into passive funds where the fund simply tracks the entire market very cheaply. To see the contrast between active and passive fees, say we invested £100. We can either put it into a very cheap US equity tracker where the cost would just be 7 pence per year, or we could put it into an actively managed hedge fund (hedge fund minimum investments are often in the millions, this is just illustrative!).
These have very high fees and their fund managers are supposed to be very skillful. For the hedge fund we pay £1.40. One of the chief instigators of this passive revolution is John Bogle. He is a founder of the US money management company Vanguard and this is a potted summary of his investment approach. He says select low-cost funds, and if you do take advice consider the cost of that advice very carefully. Don't stampede into the funds which have the greatest performance recently because, as we've seen, it's unlikely that that outperformance will persist. Of course we don't ignore past performance altogether.
We can still look at consistency and risk based on those historic returns. But we should be aware of the culture of celebrity in fund management because the stars of today will probably not be the stars of tomorrow. Fund size is also very important. Go for large funds where you get the greatest efficiency and the smallest trading costs and if possible try to keep your investments simple. Don't own too many funds, and once you have your fund hold it, because trading costs will eat away your profit.
The provocative title belies the fact that fund management is a very demanding job. It draws the brightest people and they work extremely hard and (most) see the job of managing other people's money as a privilege. However the evidence is very clear: it doesn't matter what resources you have or how intelligent you are, it seems like humans simply cannot consistently beat the markets.