You Can't Beat the Market
Market outperformance is the reserve of the legendary few
The Rise of Passive Investing
Disillusioned with active management John (Jack) Bogle, the father of passive investing, wrote a thesis at Princeton University in 1951 that laid the foundations of passive investing. You can read some excerpts here. Then, in 1976, some 25 years later, after a market crash, he founded the Vanguard Company, and the first index fund was launched. Today, passive funds of various types across sectors, industries, and themes have sprung up. Coupled with the rise of exchange-traded funds, you can now invest in indexes like the DJIA or S&P 500, technology, healthcare, small-cap growth, commercial real estate, cyber security, or clean energy through your stock trading account.
All of these passive funds have one thing in common: they aim to generate an average return for their given investment theme at a very low cost. Invest in a clean energy index fund and receive the average return of clean energy stocks for a very low fee.
The largest passive fund by assets under management is Vanguard’s Total Market Index Fund, with $1.3 trillion under management. The nearest actively managed equity fund is The Growth Fund of America, with $214b under management (which has largely tracked the S&P 500's performance).
Index funds are often called passive in that you don’t have to make decisions; you are passive, but they are really systematic investment strategies. They follow a simple set of rules, e.g., Vanguard’s VUAG S&P 500 index fund, for buying and selling stocks. Decisions to buy and sell are made according to these rules in order to, as closely as possible, replicate the underlying index. So they are not really passive; think of them as automated, rule-based, or systematic systems.
According to Statista, passive funds in the US have grown from 7.5% of assets in 2000 to 28% in 2022. For the world, PwC has this figure at 37% in 2022. Morningstar puts this figure slightly higher at 38%:
This has caused some concerns around market price discovery and distortions. For instance, if Meta were to report a severe revenue warning, S&P 500 funds would take no action, as long as Meta were to remain within the profitability constraints of the S&P 500 index rules. Essentially, these funds do not act on new information; business results simply aren’t the concern of market-cap-weighted passive funds. I’m not sure this is yet an issue, as there appears to be enough active investment to set prices, but it could become a problem in the future. I suspect that even index funds are traded actively as investors move between sectors or rotate into other assets, contributing to price discovery, but at an index, industry, or sector level.
Active Management Consistently Underperforms Passive Funds
SPIVA Research shows that less than 10% of actively managed funds beat their respective benchmarks over a 15 year period.
Source: SPIVA, S&P Dow Jones Indices
By how much, on average, did these funds underperform? Here’s a view of US large cap funds (equal-weighted):
Source: SPIVA US Scorecard, S&P Dow Jones Indices
With all their access to market data, news, education, company research, analysts, quants, networks of connections, and CEOs, active managers regularly underperform the market. They can’t beat the market.
Only a few legendary investors appear to be able to beat the market consistently, and for some reason, this makes us think we can imitate their success. We all think we’re above average and, therefore, have what it takes to beat the rest. Peter Lynch thinks that you can beat the market with some simple rules. But can you follow those rules week in and week out while the market bombards you with quick wins, sure things, and heart-stopping crashes?
So the answer is clear: invest in passive funds. But not so fast! One study found that 61% of active managers, when classified by an active share greater than 60%, beat the market after fees.
Why do Active Managers Underperform?
Fees
These can be a big drain on performance, especially for funds with high ongoing charges.
Initial: not all funds charge this but it can be up to 5%.
Ongoing: between 0.5% and 1.5%. This study found actively managed equity mutual funds have average fees of around 0.74%. Passive funds often have fees below 0.1%.
Performance: 20% is common among hedge funds or private funds.
Exit: St Jame’s Place recently bowed to pressure to scrap their 6% charge.
Some or all of these are expressed as an ‘expense ratio’ of the net assets under management, so you can gauge how much the fund will erode your gains by each year. Here’s how a 1% reduction in performance due to fees affects returns over 20 years:
Interestingly, some funds underperform the market by less than their expense ratios, indicating that they are generating alpha at the gross return level, but the alpha generated is eroded by fees. One study found that a subgroup of funds outperformed the market by 2.61% at the gross level, and outperformed by 1.26% after fees.
Holding Cash
Active managers need to hold cash in order to honour client redemption requests and avoid fire sales. They may also be holding back cash, rotating into bonds or money markets, or concerned about stock market overvaluation and waiting for a better opportunity (although timing the market is impossible). They may have accumulated income and have yet to deploy it. They are rarely close to 100% invested, like an index fund.
With the S&P 500 returning 6.87%, including dividends, over the past 23 years (2000–2023), an average 5% cash position earning money market returns over the same period cost an active manager about 0.28% per year. A 10% cash position on average cost 0.55% per year. Taking a narrower view, over the past 10 years, the S&P 500, including dividends, has returned 12.84%. Holding an average 5% cash position cost you 0.62%, and holding 10% cash cost you 1.24% in performance.
Skill & Scale
"As the size of the active mutual fund industry increases, a fund׳s ability to outperform passive benchmarks declines." - Scale & Skill in Active Management
“Although a manager can be skilled, the job is made harder as investors recognize and reward that skill” - Why Active Managers Have Trouble Keeping up With the Pack
Skill tends to attract assets under management as success leads to inflows from investors or the migration of managers to larger funds. The more funds under management, the more active managers are going to bid up stocks and erode any potential gains.
Consider what would happen should small-cap investing become popular: inflows will lead to more buying that will raise prices and erode future returns, unless you were in the market before the buying began.
Scale also prevents funds from investing in great opportunities in smaller capitalisation stocks. It simply isn’t worth their time to invest 0.1% of an $80 billion fund in a small-cap opportunity. You’d need 1,000 such opportunities.
Boundaries & Restrictions
A lot of investment funds have boundaries around what they can invest in, e.g., large-cap growth or small-cap value. There are geographic restrictions, US only equity funds can’t take advantage of opportunities in other markets. Value funds can’t invest in great growth opportunities. Credit ratings may limit what businesses a fund can invest in.
They also have regulatory requirements, such as risk management or investment restrictions, apparently designed to protect investors.
Berkshire Hathaway has a concentration of 50% in Apple within its equity portfolio. Scion Asset Management has 17.43% invested in Stellantis. These kinds of concentrations aren’t possible within most active funds due to the SEC’s investment concentration limits and liquidity rules.
Diversification
Diversification is not always good. A little will help you avoid an Enron, but extensive diversification can reduce returns, unless you are a low-fee index fund! How can you “know what you own” when your fund has 50+ positions? Over diversification compensates for a lack of research.
Concentrated funds with higher levels of tracking error display better performance than their more broadly diversified counterparts - Global equity fund performance, portfolio concentration, and the fundamental law of active management
Essentially, funds that deviate from their underlying benchmark and concentrate risk have better performance. If risk reduction is your concern and not potential returns, then by all means diversify till your heart’s content. Better yet, invest in a passive index fund.
Capital Markets Asset Pricing Model & Variants
This is a rabbit hole, but I don’t believe the majority of the market’s participants are rational. We have repeatedly seen the effects of irrational market participants. Behavioural Economics has a lot to say about this.
I’m also not keen on the use of beta as a measure of systematic risk. While the CAPM does acknowledge that beta can vary, it implies that the past (beta) can predict the future. I haven’t found any convincing evidence of this. Also, 1 year, 2 year or 5 year beta? What should we use? And against what benchmark? S&P 500? Nasdaq 100? Alphabet’s 3 year beta has varied from 0.99 to 1.18 over the past 5 years and has returned 145.5% in that time. Block had a 3 year beta of 3.87 5 years ago and has returned 2.6% over those 5 years.
In CAPM, the investor is expected to diversify away unsystematic risk—risk that is unrelated to the market—but how do you do that? What percentage of unsystematic risk was diversified away from COVID-19? If unsystematic risk can’t be accurately calculated, how do you know what percentage of unsystematic risk you have eliminated for a diversified portfolio of 50 stocks? Even systematic risk is not even. Consider a furniture retailer like Lovesac; does it have the same systematic risk as every other furniture retailer despite continuing to grow and take market share? Or should we consider its systematic risk to be lower? This market share gain is an unsystematic risk to other retailers.
Following the CAPM is a great way to underperform the market. Although, in theory, you’ll have a smoother return, which may help you sleep at night.
Questionable Valuation Techniques
Much research has been done on valuation being a key factor in portfolio performance, yet many funds still hold fairly obviously overvalued stocks. There could be many reasons for this, e.g., the size of holdings; selling could push the market back down and erode paper gains. I’m very sceptical of the decision making process around valuation. ARK’s Tesla valuation springs to mind. I’ll write about Tesla soon, but this valuation is all castles in the sky, IMO.
I’ve reviewed a number of fund holdings, and I can’t figure out why they purchased or own some of their positions. There are stocks out there with better valuations, yet these funds can’t seem to help themselves from buying pricey stocks with far lower probable returns. ARM Holdings has a forecast FCF yield of 2.7% (the current FCF yield is 1.4%). It will take you some 37 years to get your money back at that rate (70 years at the current rate). I suspect some psychology is at play—do you want to be the only fund not holding Tesla when it takes off again?
Other reasons…
In-active managers: some 20% of active managers are closet indexers. Throw in higher fees, greater churn, and associated transaction charges, and you have general underperformance.
Fund age: younger funds tend to outperform. I suspect because their strategies still have an edge.
Strategy popularity: funds spring up on the back of some research that gets replicated across the industry, bidding up any edge that it had.
You don’t hold Tesla: FOMO-based decision making, and all the other behavioural biases.
Too focused on macro: shifting to “safer” assets. Shifting to bonds too early has likely been a common error. Market timing is very difficult.
The next big thing: exciting opportunities in markets are often capital intensive and overpriced. I suspect a lot of investors are going to lose a lot of money on AI and space exploration, but a few will get rich. Getting FOMO?
Media attention: we’re bombarded 24 hours a day with panicky headlines. Be like John Templeton and stay away from The Street.
Job security and incentives: being at the bottom of the pack will get you fired. Being in the middle won’t. You don't need to be the best; just don’t be the worst.
Fund managers don’t do the research. They are disconnected from the underlying fundamentals and valuation, which is done by other analysts.
Analyst bias: there isn't a lot of high quality research, but there are some signs that analysts may be biassed towards institutional sales, i.e., generating revenue for the firm. There is mixed evidence on whether analyst recommendations generate alpha.
Window dressing: at year end, sell some losers to make your portfolio look a little better.
Maybe we can beat the market?
Active managers have underperformed for various reasons. At best, they are average performers before fees and expenses, with a few genuinely exceptional managers. Unfortunately, most of them can’t beat the market. If you are looking for an active manager, look for one with a high active share that’s concentrated but diverse in a new fund.
Individual investors have a greater opportunity to outperform. We aren’t held to the same boundaries, constraints, or covenants. We don’t have fund fees or expenses. We don't need to hold cash. We can invest in smaller, less well covered stocks. We can use decision making models to manage behavioural biases. We can concentrate our portfolios in great opportunities. We aren't locked into questionable analytical techniques. We do our own research and can avoid Wall Street noise.
If we exploit these advantages that we have over active management, we should be able to outperform them and also the market, IMO.