A 25% CHANCE OF SUCCESS

From The Economist Magazine, February 13, 2015
BETTING on red gives the punter an 18-in-37 chance (in Europe) or 18-in-38 chance (in America) of success in roulette. Parcel out your money carefully and you might have a diverting 20 minutes or so until it’s all gone, with a few wins along the way. If the odds were just one-in-four, then the whole game would be much more discouraging.

But those have been the chances, over the last 20 years, of largecap US mutual funds beating the market. It has happened in just five calendar years. In one sense, this is hardly surprising; professional fund managers own the bulk of stocks, so the average fund manager performance should match the index. But the index doesn’t have costs and the fund managers do. Those costs doom the fund managers to underperform. One does not have to believe in the efficient market hypothesis to understand this outcome.

But to the exent that any market is efficient, largecap US stocks is the one; dozens of analysts cover every stock and their business models are well known and understood. The chance that any investor has a unique insight into a particular company is very small.

Here are the figures from Morningstar for each of the last 20 years.

Year           % of outperforming funds    ave fund return    S&P return

1995                                 11.2                                  31.4                   37.6

1996                                 21.4                                  19.5                   23.0

1997                                 9.8                                   26.1                   33.4

1998                                24.3                                  20.5                   28.9

1999                                43.7                                  22.1                   21.0

2000                               63.6                                  -3.6                    -9.1

2001                                42.6                                 -13.8                  -11.9

2002                               39.8                                 -23.3                  -22.1

2003                               38.2                                  28.0                   28.7

2004                              43.0                                  10.2                    10.9

2005                               58.6                                   6.2                     4.9

2006                               32.8                                  12.5                    15.8

2007                                55.0                                   7.5                     5.5

2008                                37.4                                  -38.6                -37.0

2009                               59.4                                  30.0                   26.5

2010                                37.8                                  14.4                   15.1

2011                                 18.7                                  -1.6                     2.1

2012                                36.8                                  14.9                   16.0

2013                                51.8                                  32.6                   32.4

2014                                 13.4                                  10.3                   13.7

Note that 2014 was actually the third worst year in terms of the proportion of funds that managed to outperform; fewer than one-in-seven managers did so. On average, active funds underperformed by around 1.6 percentage points a year, a big handicap for clients. There was one year, 1999, when most funds underperformed but the average return was slightly higher than the market. Still, the average return only beat the market 6 times out of 20. (To be fair, if one takes the average of each of the 20 years, active funds have outperformed 37% of the time. But that’s still very low.)

To those who would say that passive funds are also doomed to underperform the market after costs, that is true, but their costs are a lot lower. A shrewd gambler would consider them a much better bet.

Of course, many people will ignore this advice. They see an index fund as a boring commodity product; they want the best in class, a manager that can outperform. And no active manager will admit that he (or she) is likely to underperform. But it is remarkable how few will put their money where their mouth is.

http://www.economist.com/blogs/buttonwood/2015/02/mutual-fund-investing

Larry C.

I’m a department head for a high school in Toronto. I graduated from the Ivey School of Business at Western University and have been a DIY investor for over 20 years.