Stock Pickers - Index Funds Advisors, Inc.


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3.1

Introduction

The most common form of active management is stock picking. On average, stock pickers will always lose by the amount of their costs and expenses. Some will do better and some will do worse than an appropriate or blended benchmark of risk factors. Since the average return of the market is the average return of all investors, the average investor gets the average return. Although you may think that you can choose or be the investor who beats the others, the probability of a money manager outperforming other managers each year is equal to getting heads on the toss of a coin: 50/50. This is because the markets are random, just like a coin toss. The chances of a manager beating a market over the long term (more than 10 years) were 1 in 36 in one study, and 1 in 39 in another 30-year study! You would be better off betting on one number on the roulette table in Vegas, where odds are 1 in 38. So far, we have collected over 200 articles measuring the performance of active managers, starting with Alfred Cowles in 1933, and the results are not good for active management.

3.2

Definitions

3.2.1 Stock Pickers

Stock pickers are active investors who bet they can beat a market by picking stocks they believe will outperform an index. To be precise, the only proper comparison to their result is the portfolio they choose. All other portfolios will end up with different risk and return characteristics. Generally, stock pickers take on more risk than the index because they concentrate their bets on fewer stocks than those in the index. When they allocate their portfolio differently than the index, they are guaranteed to obtain a different return as well as a different risk level. Sometimes it is more and sometimes it is less, but we can always assume it will be different when looking at both risk and return. Since it takes at least 20 years of risk and return data to confirm skill over luck, stock pickers face a virtually impossible task in their ability to ensure continued success against the appropriate market index. However, indexes are a source of 20-year risk and return data, and consequently are the only logical choice for establishing efficient portfolios of various levels of expected risks and returns.

3.2.2 Adjusted Performance

The performance of stock pickers must be examined on an adjusted basis. This means that all factors must be considered before we can determine if the stock picker has achieved a benefit over an appropriate index or benchmark. When comparing active management to an index, we must:

1. Make sure we are talking about the entire portfolios for the exact same period of time.

2. Confirm proper accounting of the returns, including the cash flows in and out of the account.

3. Consider the state and federal taxes paid on short and long-term capital gains and dividends.

4. Consider all fees when assessing net return. Most funds report gross performance before deduction of fees and commissions.

5. Adjust for the portfolios' exposure to market risk, size risk, and value risk factors.

6. Consider the level of diversification of the two portfolios.

7. Analyze the standard deviations or volatility measurements.

8. Consider if the over and underperformance is within the bounds of what would be expected randomly.

9. Be sure to compare results to an appropriate benchmark. Proper benchmark specification avoids inflated performance reports.

10. If looking at a group of stock pickers, be sure to include the returns of those pickers that did not survive the duration of the period, usually due to significant losses.

11. Look at all active managers in an asset class, both those who stayed in business and those who did not.