The Prescient Are Few

The question is decades old: Can professional money managers consistently pick stocks that outperform the broad stock market averages – as opposed to just being lucky now and then?

Countless studies have addressed this question, and most have concluded that very few managers have the ability to beat the market over the long term. Nevertheless, researchers have been unable to agree on how small that minority really is, leaving the industry to debate whether it makes sense for some investors to try to beat the market by buying shares of actively managed mutual funds.

Recently, a new study was concluded which used a far more sophisticated statistical analysis than we’ve seen in the past. The study, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas”, uses a sensitive statistical test (the False Discovery Rate) borrowed from astrophysics and chemistry, among other scientific communities.

In effect, the method is designed to simultaneously avoid false positives and false negatives — in other words, to avoid concluding that something is statistically significant when it is entirely random, or that something is random when it is statistically significant. Both of these problems have hampered many previous studies of mutual funds.

So, what happens when you apply the False Discovery Rate test to 30 years of data (and almost 2,100 actively managed funds)? The researchers – Professors Barras, Scaillet, and Wermers – found a marked decline over the last two decades in the number of fund managers able to pass the test. They found, for example, that 14.4% of managers had genuine stock-picking ability back in 1990; by 2006, however, they found that the proportion had declined to just 0.6% – statistically indistinguishable from zero.

This, while not surprising to those of us who have spent years standing passionately behind our “passive beats active” mantra, is yet another stunning blow to the financial services industry. It is also, one can hope, a wake-up call for those investors who still believe in active management; perhaps they will finally realize that the gamble they are taking, at significant expense, has an expected return of less than ZERO.

Why the decline?

Professor Wermers says he and his colleagues suspect several causes, including high fees and increasingly efficient markets. Whatever the cause(s), the investment implications of the study are the same: buying and holding low cost passively-managed funds is the only rational choice for most, if not all, equity investors.

The financial services industry will, of course, continue to promote its rock-star money managers, doing all they can to convince you (and themselves) that extraordinary skill (rather than luck) is the reason for their 5-Star rating. But, as we now know with certainty, it’s luck – not skill – that most often results in market-beating performance. As this study makes perfectly clear: The prescient are, indeed, few and far between. $$ Michael L. Gay, MBA, CFP®