Don’t Try to Outguess the Market

The market’s pricing power works against investors – including mutual fund managers – who try to outperform through stock picking or market timing. As evidence, only 14% of US equity mutual funds and 13% of fixed income funds have survived and outperformed their benchmarks over the past 15 years.

Many fund managers believe they can identify “mispriced” securities and convert that knowledge into higher returns. But fair market pricing works against such efforts, as indicated by the large proportion of mutual funds that have underperformed their Morningstar category index.

In the chart above, the gray bars represent the number of US-domiciled equity and fixed income funds in operation during the past 15 years. These funds compose the beginning universe of that period. The dark gray areas show the percentage of equity and fixed income funds that survived the 15-year period. The blue and green bars show the smaller percentage of equity and fixed income funds that survived and outperformed their respective Morningstar category index during the period.

There is perhaps no better test of market efficiency than the investment industry itself. In fact, active managers put market efficiency to the test every day as they research companies in a quest for mispricing. If market prices do not reflect fair value, the more skillful managers should be able to add value by finding mispriced stocks and outsmarting other market participants consistently.

Today, the investment industry takes for granted the calculation of rates of return and the availability of other data to evaluate investment performance of stocks and professional managers. But before the mid-1960s, there was neither a generally accepted way to calculate a total return nor a way to compare the returns of different funds. This all changed with the advent of computers and the collection of returns data for stocks and bonds.

Researchers began studying professional money manager performance, and for the first time, they could compare the returns of active managers to the overall market and assess whether these managers added value (after fees) through their active efforts to analyze stocks and forecast the direction of individual securities and markets. Noteworthy researchers on mutual fund returns include Sharpe (1966), Jensen (1967), Malkiel (1995), and Carhart (1997). These are only a few of many academics who asked whether professional money managers could apply their research and skills to consistently outperform the broad market. Survey papers that describe this work include Davis (2001) and Malkiel (2003).

The body of evidence has casted doubt on the value of active management. In general, the research shows that the number of successful long-term managers is no greater than what would be expected by chance. Moreover, despite their efforts to identify “mistakes” among stock prices, few professional managers demonstrate an ability to exploit mispricing. A major reason for their underperformance is the higher management fees and transaction costs required to implement active management.

Despite this evidence, however, active management strategies still dominate the investment industry, and most investors believe that smart professionals can use research to identify pricing mistakes and predict future market movements. But their efforts typically incur higher fees and trading costs, and result in higher risk exposure and lower returns for investors.