“THE harder I practise, the luckier I get,” said Gary Player, one of history’s greatest golfers. And it is a widespread belief that experienced professionals are a lot better than neophytes.
But is that true of fund managers? A new study* suggests that the answer is distinctly mixed.
The paper examined the records of 2,846 American mutual funds between the start of 1996 and the end of 2008, overseen by 1,825 managers (some looked after more than one fund). Turnover was high; fewer than a quarter of the managers lasted more than five years. Just 195 of them lasted a decade.
Unsurprisingly, those managers who were poor performers in their early years were more likely to lose their jobs. In their last year in charge of their funds, these neophytes underperformed the veterans. However, the veterans did not outperform consistently; what they did do was avoid periods where they did particularly badly. The authors concluded that “even long-term managers show no ability to beat the market on a risk-adjusted basis. The key to a long career in the mutual-fund industry seems to be related more to avoiding underperformance than to achieving superior performance.”
Another conclusion may be that it pays to start well. A few years of outperformance at the beginning of your career will establish a reputation as a star manager, and the money will roll in. At that point, it may not matter what happens next in terms of returns. A previous study by the same academics found that successful performance in the first five years of a manager’s career is not predictive of success in the following five years.
A similar conclusion was reached in a study backed by Vanguard, a manager best known for its “tracker” funds–which aim simply to replicate the market’s performance rather than beat it, as “active” funds attempt to do. It analysed the performance of equity mutual funds that had been in the top quintile (20%) of their sector, and thus might be favoured by investors. In the following five years, their performance deteriorated, with more of such managers ending up in the bottom quintile than in the top (see chart).
Why is it so difficult to be a consistent outperformer? In another paper**, Charles Ellis, an investment consultant for more than 40 years, explains the reasons. Fifty years ago, institutions did less than 10% of all trading on the New York Stock Exchange; now it is more than 95%.
In general, fund managers have access to the same information as their peers and, for liquidity reasons, tend to focus on the largest stocks in the market; this makes it very difficult to perform better than the benchmark, particularly after costs and fees are deducted. A few genuinely brilliant managers may outperform the index but it is all but impossible to identify them in advance.
Academics have been alive to this issue for 40 years; what is surprising, however, is how slow the active funds’ clients have been to catch on. Tracker funds still have only around 11% of global fund-management assets, according to a report by PwC, a consulting firm. The simplest explanation seems to be blind optimism. Mr Ellis cites a survey that shows clients expect the average manager to beat the market by a percentage point a year, after fees. Pension funds run by trade unions, bizarrely, are the most optimistic of all.
There are a number of potential explanations. Some are psychological; the “Lake Wobegon effect”, in which everyone thinks they can pick above-average managers; or what might be called the “don’t just sit there, do something” problem, in which trustees have to justify their existence by shuffling managers, rather than just buying a tracker and going to sleep.
Another possibility is that investors have to be blindly optimistic if they are to justify the high returns assumptions they have made. Public pension funds in America routinely assume returns of 7.5-8% a year even though the risk-free rate is less than 3%. If they are not going to earn these returns by tracking the index, they must assume they can beat the benchmark. As Mr Ellis tartly remarks, “among pension-fund executives, the elusive magic of outperformance is now the most favoured way of closing funding gaps.”
The best, it seems, is the enemy of the good. In the hope of earning outstanding returns, investors are paying active fund-management fees that will only dilute the modest returns they are likely to earn.
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