As we described in our related blog post, “Stop Picking Active Money Managers,” it’s very hard for clever money managers to consistently outperform the rest of the market they are targeting, especially after factoring in the costs involved. Besides, by the time you identify the few who have managed to statistically beat the odds, the chance to get on board with them has already passed you by.
Just how hard is it? The case against active management is strengthened by a bounty of studies informing us that random luck rather than persistent skill has been driving that runaway party train of past outperformance, far more often than not.
“The Selection and Termination of Investment Management Firms by Plan Sponsors” is one such study, published in the August 2008 Journal of Finance. Its authors found that institutions tended to share individual investors’ habit of chasing managers who had recently outperformed and shunning those who had recently disappointed, with nothing much to show for it. Specifically, looking at more than 3,400 plan sponsors from 1994–2003, the study found that:
- Plan sponsors tended to hire new investment managers after they’d exhibited past outperformance.
- Plan sponsors fired investment managers for a number of reasons, “including but not limited to underperformance.”
- “In a sample of round-trip firing and hiring decisions, we find that if plan sponsors had stayed with fired investment managers, their excess returns would be no different from those delivered by newly hired managers.”
If larger institutions with the resources to hire the best and brightest consultants can’t seem to differentiate between luck and skill when considering past outperformance, how are we going to succeed at it?
There’s additional compelling evidence from a 2015 Dimensional Fund Advisors paper, “The US Mutual Fund Landscape.” First, the paper identifies the small percentage of “winning” stock funds that had outperformed their benchmarks during three-, five- and ten-year periods ending December 2009. Then it looked at those outperformers during the next five years, 2010–2014, to see how they fared. Only 28% of the funds that had outperformed during the 10 years prior were able to continue their winning streak; the stats were even worse for the three- and five-year past winners.
My take on this is that there is little point in re-doubling your efforts to differentiate luck from skill and predict future winners with so little to go on as a reliable guide and odds stacked so steeply against you. The preferred approach is to STOP trying to pick active managers and their active strategies to begin with, and instead select from those who are dedicated to helping you patiently participate in markets according to your personal risk tolerance, as well as the extensive academic inquiry into what drives expected returns. Here, there is an abundance of statistical evidence to keep you on track toward your goals.