|Merton Miller from the Nova Special, The Trillion Dollar Bet|
The basic problem
with stock picking is revealed when we examine how stock pickers are
unable to beat a market over the long run. In a random and efficient
stock market, active investors are just gambling or playing a game of chance. The
money managers that run actively managed mutual funds are essentially gamblers,
paid by the unsuspecting shareholders, with a high average annual
fee of about 1.5%.
Gambling may be fun when you go to Vegas, but it is not how investors should invest their hard earned money. Consider it this way: index funds investors invest like the owner of a casino, while the active investors behave like the gamblers in the casino. Attempting to predict the stocks, times, or managers that will perform the best is NOT a profitable expenditure of time or money. Assembling a portfolio of indexes is a very different story that has a guarantee of obtaining a low-cost, tax-efficient market rate of return, which is better than about 95% of stock pickers over 10 or 30-year periods.
A survey of both the popular and academic literature provides a crystal clear picture of the daunting odds of stock picking. Robert Jeffrey and Robert Arnott published a study titled, “Is your Alpha Big Enough to cover its Taxes?” In the study, 71 large cap growth and growth and income active mutual fund managers were compared to the S&P 500 over a period of 10 years from 1982 to 1991. Most invested in styles that closely represented the S&P 500, but not one was exact. Only two of these 71 managers beat the index. That is a mere 3%! Had they all just invested in the S&P 500, they would have equaled its return. For those investors who were invested in either of the two funds that did beat the S&P 500, very few enjoyed the full returns of these funds. This is because huge cash inflows showed up in the last year of the time period, a typical sign indicative of manager or stock picking. See Figure 3-2.
The odds of throwing a two (snake eyes) at the craps table are the same as the results of this study, one in 36. The least likely rolls of a pair of dice are two and 12. The odds in roulette are one in 38 for picking a one-number winner. Gambling in Las Vegas may lead to more success than trying to find a manager who beats a chosen index at the beginning of the period. Says John Bogle, founder of Vanguard: “Investors earn a net return, after all of the costs of our system of financial intermediation. Just as gambling in a casino is a zero-sum game before the croupiers rake in their share and a loser’s game thereafter, so beating the stock and bond markets is a zero-sum game before the intermediation costs, and a loser’s game thereafter.”
The odds of throwing a two (snake eyes) at the craps table are the same as the results of this study, one in thirty-six or 2.77%. Two and twelve are the least likely rolls of a pair of dice. Try it on the image to the right.
Rex Sinquefield, Co-Chairman DFA
Click on the button in the bottom left corner and see how long it takes you to get snake eyes. Dice Experiments
To illustrate the daunting odds of success for stock pickers, take a look at these studies.
Cowles conducted one of the first recorded studies of stock pickers’
performance in a July 1933 article titled, “Can Stock Market Forecasters
Forecast?” He concluded that it was “doubtful.”
In another study titled, “Bogle on Equity Fund Selection,” Bogle determined that only nine out of 355 equity funds beat their benchmark over a period of 30 years. Interestingly, that is 2.5% or a one in 39 chance of choosing the correct mutual fund in advance. Another study using CRSP data showed similar results. See Figures 3-3 and 3-4.
In a similar analysis by a different firm, and using a different database and a slightly different time period, very similar results were determined.
A study by Brad Barber of the University of California David titled, “Who Gains from Trade? Evidence from Taiwan,” showed that 82% of the 925,000 active traders on the Taiwan stock exchange lost $8.2 billion per year from 1995 to 1999.
Another stock picking study titled, “The Importance of Investment Policy,” conducted by Ronald Surz, Dale Stevens, and Mark Wimer found that the market timing and stock picking done by active managers had a predictably negative effect on returns. Active management created a negative drag compared to a portfolio of index funds that most closely replicated the active manager’s asset allocation. Adjustments were not made for taxes in taxable accounts. These findings indicate that asset allocation contributes to more than 100% of the expected return of an actively managed portfolio.
The case against active management is clearly and logically spelled out by Nobel laureate William Sharpe in an article titled, “The Arithmetic of Active Management.” In the article, Sharpe clearly states that before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar, and after costs the return on the average actively managed dollar will be less than the return on the average passively managed dollar.
The findings of another study by Sharpe titled, “Asset Allocation:
Management Style and Performance Measurement, an Asset Class Factor Model
can Help Make Order out of Chaos” supported the hypothesis that
the average mutual fund cannot beat the market before costs. That’s
because such funds constitute a large and presumably representative part
of the market. Annualized, the mean underperformance is approximately
0.89% per year—an amount that is approximately equal to the costs
incurred by a typical mutual fund.
In a study titled “Are Investors Reluctant to Realize their Losses?”, Terrance Odean, using 10,000 random discount brokerage accounts, demonstrates that the trading volume of discount brokerage clients is excessive. Overconfident investors overestimate the amount of profit they can make and will thus engage in costly trading, even though the profits will not cover the associated costs. Overconfident investors also believe they have discreet, useful information when in reality they have no such knowledge. Odean found that stocks that investors purchased underperformed securities they sold!
In a follow-up study titled, “Trading is Hazardous to Wealth: The Common Investment Performance of Individual Investors,” Odean along with Barber analyzed 66,465 individual trading accounts. They found that from 1991 to 1996, investors that traded the most earned an annual return of 11.4%. In the same time period, the market returned 17.9%. The simple conclusion: Active investment strategies will underperform passive or indexed investment strategies.
In another study by
Odean and Barber titled, “Too Many Cooks Spoil the Profits: The Performance
of Investment Clubs,” 166 investment clubs were followed from February
1991 through December 1996. Many people belong to investment clubs, which
are touted as a valuable way for investors to learn about the markets.
Of the total investment clubs, 57% underperformed the market.
In a study titled, “The Performance of Mutual Funds in the Period 1945 to 1964,” Michael C. Jensen tested the predictive ability of 115 mutual fund managers in the period 1945 to 1964. He was interested in gauging their ability to earn higher returns than those that would be expected, given the level of risk of each of the portfolios. What he found was that on average, the 115 mutual funds were not able to predict security prices well enough to outperform a buy-the-market-and-hold policy. In addition, there was very little evidence that any individual fund was able to do significantly better than that which was expected from mere random chance. Jensen’s conclusions held up even when fund returns gross of management expenses were measured.
In a study titled, “Mutual Fund Performance and Manager Style,” James Davis looked at the relationship between fund performance and manager style. Two specific issues were addressed. First, did any particular investment style reliably deliver abnormal performance? Second, when funds with similar styles were compared, was there any evidence of performance persistence? The results of the study were not good news for investors who purchased actively managed mutual funds. According to the findings, no investment style generated positive abnormal returns over the 1965 to 1998 sample period.
Edwin Elton, Martin Gruber, M. Hlavka and Sanjiv Das studied all 143 equity mutual funds that survived from 1965 to 1984. These funds were compared to a set of indexes comprised of large cap, small cap, and fixed income, that most closely matched the actual investment choices of the funds. The result: on average, these funds underperformed the indexes by a whopping 1.6% per year, before federal and state taxes. Not a single fund generated a positive performance that was statistically significant.
A far more comprehensive study of 1,892 funds that existed in any period between 1961 and 1993 became the dissertation of Mark Carhart, while he was earning his Ph.D from the University of Chicago. The study titled “On Persistence in Mutual Fund Performance” found that when adjusted for the common factors in returns, an equal-weighted portfolio of the funds underperformed the proper benchmark by 1.8% per year, before federal and state taxes.
In the first major study of bonds funds, Christopher Blake, Edwin Elton and Martin Gruber examined 361 bond funds for the period starting in 1977. They compared the actively managed bond funds to a simple index alternative. The result: the actively managed bond funds underperformed the proper benchmark by 0.85% per year, before federal and state taxes.
A study by Brad Barber, Reuven Lehavy, Maureen McNichols and Brett Trueman titled, “Prophets and Losses: Reassessing the Returns to Analysts’ Stock Recommendations,” analyzed the returns to analysts’ stock recommendations over the 1996 to 2000 period. The period was one of growing doubt about the value of these recommendations, as analysts became increasingly involved in the investment banking side of their business. The study showed that the more highly recommended stocks earned greater market-adjusted returns during the 1996 to 1999 period than did those that were less highly recommended. However, the opposite was true for 2000, as the least favorably rated stocks earned the highest returns. These missed predictions of stock pickers prevailed during most of 2000 while the market was rising and as it was falling.
Henry Blodget took a hard look at active management, and he came to this conclusion: "Academics have essentially proved that active fund management, for the fund customer, is a loser's game. The vast majority of active funds underperform passive benchmarks. So the vast majority of customers of active funds pay billions of dollars in exchange for, at best, nothing."
DFA looked at 31 institutional pension plans with $70
billion in total assets. The firm found that when the returns were properly
risk adjusted using the Fama/French Three-Factor Model, at least 95% of the returns
were explained by the three risk factors, and the value added by active
management was statistically insignificant, even before fees.
When Jeff Brown of TwinCities.com wrote an article titled, “Beating Index Funds Takes Rare Luck or Genius,” he asked Morningstar to look at the record of mutual funds. The independent investment research firm determined that there are 1,446 large-cap blend funds that invest in a similar asset class to the S&P 500. Over the 10-year period ending October 2004, only 35 mutual funds matched or beat the performance of the S&P 500. That’s only 2.4% or one in 41. See Figure 3-6. Morningstar also looked at the last three years, and only 22 out of the 1,446 funds consistently beat the S&P 500. Brown’s sobering conclusion was that “if such a small percentage beat the index, many of them do it with luck, and there’s no way to identify those that really are brilliantly managed…well that’s why index fund investing is so attractive.”
Jeff's sobering conclusion was that, "If such a small percentage beat the index, many of them do it with luck and there's no way to identify those that really are brilliantly managed... . Well, that's why index-fund investing is so attractive."
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