Secrets of Success: Are our fund managers batting better?

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The Independent Online

An interesting article by the American economist Peter Bernstein invites us to address the following question: are professionals in the investment business starting to perform better? He raises this because recent data suggests that, after years of being trounced by the market that they are supposed to beat, professional fund managers have started to produce rather better results, in the United States market at least.

When Mr Bernstein last examined this issue six years ago, he compared the declining relative performance of professional fund managers to the decline of the batting superstars in baseball. No hitter in baseball has averaged 400 in a season since 1941, he pointed out, and the dispersion of batting averages between the best and the worst player has narrowed considerably over the same period.

The baseball trend is the result not of any loss of skill by individual players, but of the undeniable fact that baseball has become a much more professional and competitive sport. Players are fitter, better coached and more keenly matched than they were in the glory days.

So too, argued Mr Bernstein, it has been with professional investment managers. The average fund manager is not less knowledgeable or less skilled than in the past; in fact, the talent and quality of the people in the business is much higher than it was even 20 years ago. The knowledge, training and access to information that fund managers enjoy today is light years ahead of where it was.

So, if it is not skill that is declining, what else could explain the fact that the fund management business has been experiencing exactly the same trends as baseball? The data six years ago showed clearly not only that the ability of professionals to beat the market was declining, but that the dispersion between best and worst performer was also narrowing, just as in baseball.

Mr Bernstein's suggestion was that the answer lay in the increasing efficiency of the market. The reason that professional fund mangers could no longer outperform so readily was precisely because they are now in a much more competitive environment, in which the general level of skill and sophistication is preventing exceptional talents from shining in the same way as before.

What are we to make of the fact that this trend appears to be reversing? Having re-run his data from different sources, covering a wide range of professionally managed funds, they all appear to be telling the same story. Not only are more professionals beating the market, but the gap between best and worst performer has also started to widen once more. So, can we conclude that we are witnessing at least a temporary decline in market efficiency, for reasons as yet unexplained?

Mr Bernstein is canvassing opinions on this question which if the answer were yes and sustained into the future, would have important implications for investors, but he has yet to formalise his conclusions. One clear implication of his findings that the relative performance of professional fund managers has improved is that other investors in the market - notably private and foreign investors, who are not included in the data set - must by definition have been doing a lot worse (which is plausible).

Although I have not had time to check whether the same trends have been happening in the UK market, my impression is that the same is probably true here as well. The first obligation when surprising trends emerge is to look more closely at the data. Part of what has happened may be a phenomenon to do with style factors.

It is, for example, well known that, historically, the majority of unit trusts in this country have tended to be biased towards small and mid-cap investment strategies. As a result, they did particularly badly in the last years of the 1995-2000 bull market, when all the action in the market was in the large cap area. Since 2000, that trend has reversed, and you would expect relative performance of actively managed funds in the unit trust sector to improve (though this, in turn, has been balanced by the growing number of index and closet index funds within the UK equity sector).

Another factor is that there is an obvious difference between bull and bear markets. Managing portfolios through the two types of market requires different skills and temperaments. Given that most professional fund managers had never lived through a really bad bear market when the market hit the rocks in 2000, it would be no surprise to find the difference between the best and worst performers widening in those circumstances. (This would also explain why private investors have fared less well).

One fact that Mr Bernstein notes with interest, however, which might invalidate the previous point, is that the reversal of trend he detects appears to have started in 1997/98, some two years before the bull market ended. But as we now know, for the majority of the stock market, the bear market did, in fact, start in 1998, not 2000. It was only a narrow segment of the market, focused around the telecoms, technology and media sectors that led the market to its peak in the final stages of the bull market. Whatever else you may wish to say about that extraordinary phase in stock market history, the one thing you can say with certainty is that it hardly counted as a triumph for market efficiency.

One conclusion that can be drawn from Mr Bernstein's data is that nothing stays constant forever in financial markets. The investor needs to be constantly vigilant about the trends that are taking place. There clearly can be times when it is appropriate to rebalance the mix between index and actively managed components in your portfolio, just as there are times to re-evaluate the balance between bonds and equities, and between value and growth stocks.

jd@intelligent-investor.co.uk

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