James Featherstone finds out whether self-proclaimed ‘superstar’ asset managers are actually telling porkiess

You would think, with all the evidence that has piled up over the last few years, that nobody in their right mind would put any money into an actively managed investment fund.

Let’s take just three bits of evidence off the top of a tottering pile. A survey carried out last year by the WM Company, which researches this sort of stuff for a living, found that over the past 20 years, 79 per cent of UK active funds failed to beat the benchmark FTSE All-Share index.

Forbes magazine produces an ‘Honor Roll’ of US mutual funds each year, supposedly picking out the best performers. Someone went back and checked whether these supposedly wonderful fund managers actually performed in the long run. Not one fund – all actively managed – in 16 years beat the Standard & Poor’s 500, the US’s main stock market index.

Finally, the New York Times pitted five senior equity fund advisers (one of them the boss of fund analysis company MorningStar, a big fish in the industry which itself rates active mutual funds) against the S&P 500 over three years. They underperformed by an average of 5 per cent a year. An update on the study in 1999 found that the best-performing stock-picker had returned 157 per cent over a six-year period while the S&P 500 had returned 250 per cent.

What does all this (and, believe me, there’s more) tell us? Mainly, that anyone telling you they can consistently beat the stock market is either a liar or a self-deluding fool. The overwhelming mass of evidence shows that actively managed equity and bond funds underperform the market consistently.

This is pretty serious. Anyone who has travelled on the London Underground in recent times will know that the platforms are plastered with adverts for active fund management companies. Invariably, these billboards contain some nugget of bragging about past performance implying, first, that such performance will continue into the future (the evidence shows that it will not) and, further, that their own clutch of managers are smarter than their peers to have produced such returns (the evidence shows that that claim won’t be true either).

Taken all in all, an average actively managed stock fund will underperform its benchmark by 2–2.5 per cent per year, while actively managed bond funds underperform their benchmarks by about 1 per cent. That’s taking into account management fees, trading costs and other such expenses.

Why do these funds underperform, though? Why shouldn’t the efforts of what are certainly some brainy people produce returns higher than you’d get from merely passively following the market with a tracker fund?

Most academics who have looked at this will tell you that it is not just unlikely that active managers will outperform, it is logically impossible. They point to the ‘efficient market hypothesis’ to explain why. This theory says that since all useful information available to market participants is already factored into a company’s share price, additional analysis of a share by, say, peering harder at a company’s accounts or wandering around some factories will be pointless. Asset management companies spend enormous amounts of money squeezing out the last drop of market information from companies. How can someone outperform if all share-price-affecting information is already out there, factored in?

Another reason put forward to explain why active managers underperform is to do with basic logic. If the performance of the market is simply the sum of all investors within it, then logically half of them must underperform. You can’t have a situation like Garrison Keillor’s Lake Wobegon, where all the children are above average. And yet each active manager says that he can outperform his peers. At least half of them must be telling porkies even before they’re put to the test.

Sometimes, you get the feeling that the industry knows that something is rotten at its heart, but doesn’t really want to let on. Morningstar, for instance, which earns its bread and butter by rating the best active equity funds, includes this disclaimer in its main funds handbook: “A rating is neither a predictive measure nor a buy/sell recommendation”. What are they for, then? And why does Morningstar feel the need to slip that caveat into the small print?

Similarly, last year in the US a book was published which aimed to exlode what it called a ‘great conspiracy’ by the mutual fund industry. The book, The Great Mutual Fund Trap, was furiously ignored by the financial press, to nobody’s great surprise. Pointing out that the basis of the industry is on the verge of being fraudulent is not going to endear you to its practitioners.

So what price the ‘superstars’?

So are active stock-pickers charlatans? Or just useless? Not quite. For a start, although they underperform the market, they’re better at investing than private individuals. One US study found that self-managed portfolios returned 5.3 per cent per year during the long bull market (1984 to 2000) compared to an average S&P return of 16.3 per cent. Active managers underperforming that S&P figure are still likely to be beating private investors.

Second, despite the fact that the majority of active fund managers underperform, a few star managers do outperform – for a while, at least. A recent paper* showed that a ‘minority sub-set’ of managers do generate enough ‘alpha’ to cover their extra costs on a consistent basis. They are the ‘superstars’ of the industry who are able to employ, it would appear, smarter conceptualisations of the market than their peers. Asset management companies compete to employ these putative superstars. But, for the average investor, finding out who they are, supposing they do exist, is next to impossible – especially since, being superstars, they get poached on a regular basis. That causes its own problems for investors because the company will continue to trumpet good performance figures, despite the person who produced them having left for another firm.

The brutal truth is that since investment ought to be a sober, long-term affair, investing in market-tracking funds is a wiser idea than investing in the supposed skills of a professional asset manager. It is cheaper for a start, with annual fees of 0.5 per cent on average, compared with up to 2.5 per cent for actives. That has a huge effect on long-term returns. It is also guaranteed (barring some disaster like the company going bust) not to underperform the market, although trackers will fall when the market falls.

Active management is a legacy of the long, irrational bull market which lasted for 20 years from the early 1980s. You can’t beat the market.

*Can Mutual Fund ‘Stars’ Really Pick Stocks? New Evidence from a Bootstrap Analysis. Robert Kosowski, INSEAD; Allan Timmermann & Hal White, University of California, San Diego; Russ Wermers, Robert H Smith School of Business, University of Maryland.