'The weak players are leaving the poker table,' and it's killing mutual funds

Warren buffett poker gamblingAP ImagesWarren Buffett, center, of Berkshire Hathaway Inc., stacks his chips Thursday, Dec. 7, 2006, at a charity poker tournament in Omaha, Neb

Warren Buffett famously said that if you’ve been in a poker game for half an hour and “you don’t know who the patsy is, you’re the patsy.'”

When it comes to the stock market, the patsy is leaving the table. That’s according to a big note from Credit Suisse strategists led by Michael J. Mauboussin.

The investment world has seen an accelerating shift from active fund managers to passive management
, and this trend is shaping the way the industry operates.

“The investors leaving active managers are likely less informed than those who remain,” Mauboussin said. “This is equivalent to the weak players leaving the poker table. Since the winners need losers, this can make the market even more efficient, and hence less attractive, for those who remain.”

In other words, as investors shift their allocations to passively managed funds, the most popular being exchange traded funds, it is getting harder for active managers to make money. That, in turn, helps further accelerate the flow of assets to passive managers.

Mauboussin includes the chart below, showing that on average only 41.5% of actively managed US equity funds outperformed their benchmark in each individual year from 2000 to 2015. Just 12.6% have outperformed over the past three years. The performance has been especially grim in recent years, with just 12.8% beating the benchmark in 2014, and 25.2% beating the benchmark in 2015.

With that in mind,
Mauboussin has some advice for active managers. The note said:

“The question any active fundamental investor must ask constantly is, “What is my source of edge?” An equivalent question is, “Who is on the other side?” Possible sources of edge include better information than the market, sharper analytical skills that allow you to better interpret data, a different time horizon, and the liquidity to take the other side of investors making behavioural blunders. One provocative idea is to start the investment process with a screen for potential inefficiency rather than, for example, cheap stocks.”

Mauboussin has some advice for individual investors too: you can’t lose if you don’t play the game. He said:

“Indexing makes a great deal of sense for investors who do not have the time or sophistication to evaluate investment managers. This is relevant for most individuals. These investors should focus on allocating assets appropriately and minimising costs.”

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