Why the markets outperform the professionals' managed funds most years
Saturday 15 February 1997
It seemed that those funds which were "actively managed" had come out on top again in the performance stakes.
The early returns suggested that while the FT All-share index last year produced a total return of 16.8 per cent, the average actively managed pension fund had achieved a return of 17.2 per cent, a small but significant advantage.
If confirmed, it would have meant that professional fund managers collectively had beaten the main stock market index for only the third time in the last 10 years.
But alas, for the industry's self-esteem, the first cut proved to be a false signal. A month on, there has been time to collect and analyse the performance data further, and now the figures have had to be revised. WM, which monitors results from 80 per cent of the pension funds in this country, now calculates that the outcome last year was a dead heat. The pension funds in its survey produced a return of 16.8 per cent - exactly the same as the index itself had produced.
In historical terms, this was still quite an achievement. For ever since professional fund managers started to analyse their performance in detail (which was not all that long ago), the message has almost invariably been the same. In any one year, the majority of professional fund managers are incapable of beating the main stock market indices.
And if that were not bad enough, the chances of any fund manager beating the index repeatedly over a period of years are much slimmer still.
The evidence on this point, as I have had cause to mention here before, is quite incontrovertible. Every study that has been carried out into fund management performance, whether it is in the United States or here, and whether it is pension funds, unit trusts, investment trusts or whatever, arrives at roughly the same conclusion. This is that around 80 per cent of professionally managed funds will underperform the market as a whole each year.
WM's own data shows that 1992 was the only year in the last 10 when pension funds actually made a return greater than that of the index (though in 1994, they did manage to produce a smaller negative return than the index).
If you look at studies of individual fund management performance over time, the evidence is similarly clear-cut. Fund managers who appear in the top 25 per cent of performers in any five or 10-year period are more likely than not to be in the bottom half in the succeeding five or 10- year period, In fact, there is some evidence to support the view that picking the worst performing fund management group is just as likely to produce above average performance in the future.
Credit for the first discovery of this painful truth about the fund management business is probably owed to a distinguished American philanthropist, Alfred Cowles, who demonstrated as long ago as 1933 that the returns achieved by insurance companies were no better or no worse than those which would have been generated by a randomly selected portfolio of stocks. But it has taken the advent of modern computers to demonstrate conclusively quite how persistent and relentless this phenomenon is.
When you think about it, of course, this finding is really not as surprising as it may seem. Fund managers collectively are the market, so it is inevitable that collectively they should be unable to beat the market index. The main reason they persistently fail even to match it, however, lies in the cost of their doing business - their management fees on the one hand and all the money they put into the pockets of stockbrokers when they buy and sell the shares in their portfolio.
While the average fund manager cannot beat the stock market, many individual fund managers can - and do. In the pension fund field, the top quartile of performers typically produce a return that is between 2 per cent and 6 per cent greater than the market as a whole.
Something similar happens in the unit trust and investment trust industry, although most cases of outperformance are due more to the particular sector or country that the trust has chosen to invest in, rather than the stock selection skills of the manager in question.
What is odd is that it has taken so long for investors to arrive at the obvious conclusion - that it may not be worth trying to beat the stock market index any more. Naturally, everybody wants to see their fund in the top half of the performance tables - pension fund trustees are just as dogmatic about that as the average investor.
But is it sensible to set that as a target? As there is now a practical alternative, in the shape of index-tracking funds, whose sole raison d'etre is to mimic the returns on the index, without any pretensions to beating the market averages, the question needs careful consideration.
Not for nothing do WM now estimate that between 20 per cent and 25 per cent of pension fund money is now "passively" managed - ie invested in index-tracking funds. In the United States, the figure is more like 40 per cent. It is the inevitable consequence of taking a long, hard look at the facts of past performance.
Now that ordinary investors have a chance to put their money into an index-tracking fund too - there are already nearly a dozen such funds in this country - the question to ask is not whether you should think about them as an investor, but why you should even think of opting for anything else.
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