investors agree that the U.S. financial markets are highly efficient.
But are other markets outside the United States efficient? Are there
profitable investments that can be made that might outperform their
respective index? Many investors believe that these “underdeveloped” markets
are inferior to our own, and that analysts are better at choosing stocks
in international markets that outperform the appropriate index. Evidence
shows that this is not the case.
Several studies have proven that the indexes of these smaller markets, on average, will perform better than an active fund. If one investment manager has an idea about an international country or company, it would only be logical to have numerous other firms investigating the profitable possibilities, with only one conclusion available—that none of the firms will outperform the index average over any lengthy period of time.
In fact, there have been studies that show higher costs associated with international investing make it even harder for active investors to beat their benchmarks. In a research paper by Garret Quigley and Rex Sinquefield titled, “Performance of UK Equity Unit Trusts,” the authors concluded that UK money managers were unable to outperform markets in any meaningful sense.
Meanwhile, a study by Cambridge Associates looked at U.S. Small-Cap manager performance form 1995 to 2004. Specifically, the survey looked at the persistence of U.S. small-cap manager performance across two five-year periods: 1995 to 1999 and 2000 to 2004. Of the managers in the top quintile of performance in the first period, 59% landed in the bottom quintile in the following period. A full 97% ended up in the bottom two quintiles. In addition, more than half of the managers in the second best quintile in the 1995 to 1999 period dropped to the bottom two quintiles in 2000 to 2004. The point: there is no evidence to suggest consistency in manager performance. A couple of managers post great performance over an extended period of time. But, the reason is most certainly luck.
people are led to believe that active managers can provide a greater
advantage and higher value to investors in the small-cap versus large-cap
market, thus resulting in a larger alpha. A large alpha infers that
the stock or mutual fund has performed better than would be expected
based on its volatility or risk, suggesting that active management
is the reason for the better than expected performance.
Richard M. Ennis and Michael D. Sebastian of Ennis Knupp + Associates, one of the 10 largest pension consulting firms, published a paper titled “The Small-Cap-Alpha Myth,” in September 2001. In the study, the firm constructed a sample of 128 small-cap managers from the Mobius Group M-Search database, a small-cap database of institutional commingled funds and composites of separate accounts. The researchers concluded that this so-called small-cap-alpha advantage is actually the “small-cap-alpha myth.” At first blush, it appears that a small-cap-alpha advantage does exist. But when looking at the 10-year period ending June 30, 2001, their research showed that the median portfolio in their sample outperformed the Russell 2000 Index by 4.04%. A more accurate picture formed when they delved deeper.
When three important performance evaluation methods were considered, the alpha diminished to virtually zero. These performance evaluation errors include (1) neglecting to account for management fees, (2) comparing the portfolio to an inappropriate benchmark, and (3) overlooking survivorship bias.
Error #1: Ninety percent of the products in the sample reported performance before fees. When fees were included in the equation, the stock picker’s advantage dropped from 4.04% to 3.09%.
Error #2: To derive an accurate net return, appropriate benchmarks must be used for comparison. A single index, such as the Russell 2000, cannot be used for proper comparison if the portfolios being compared are not exactly the same in style and make-up as that index. Ennis and Sebastian created effective style mixes (ESMs) for the products being studied. Based on a type of multiple regression, ESMs are a more precise way to benchmark. Now accounting for errors #1 and #2, the adjusted alpha dropped from 4.04% to 1.2%.
Error #3: Many databases do not include the records of stock pickers that went out of business, which hyper-inflates the performance reports of active managers and funds. This survivorship bias does not accurately reflect the true performance of all managers that started at the beginning of the period.
When considering all three performance evaluation errors, Ennis and Sebastian concluded that the true median alpha in their sample is “likely to be zero or negative, not 4%.” In conclusion they found “no support for the claim that active management of small-cap portfolios is any more fruitful than it is for large-cap portfolios.” In other words, forget about it! Focus on the only important question of investing: What allocation of index funds is most appropriate for you?
Many studies show that individual and professional investors consistently underperform market averages. A visit to our article database of research studies will demonstrate the vast amount of research in this area. Several relevant studies are summarized below, some of which are shown elsewhere in the ifa.com website.
1. False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, Barras, Laurent, Scaillet , O. and Wermers, Russ R., "False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas" (April 20, 2009). Journal of Finance, Forthcoming; Swiss Finance Institute Research Paper No. 08-18. Available at SSRN: http://ssrn.com/abstract=869748
Abstract: This paper develops a simple technique that controls for “false discoveries,” or mutual funds that exhibit significant alphas by luck alone. Our approach precisely separates funds into (1) unskilled, (2) zero-alpha, and (3) skilled funds, even with dependencies in cross-fund estimated alphas. We find that 75% of funds exhibit a zero alpha (net of expenses), consistent with the Berk and Green (2004) equilibrium. Further, we find a significant proportion of skilled (positive alpha) funds prior to 1996, but almost none [no alpha] by 2006. In a July 2008 New York Times article titled, “The Prescient Are Few”, journalist Mark Hulbert digs into the results of the landmark study and its implications as described by Prof. Russ Wermers who headed up the study: “The number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives,” says Prof. Wermers -- or as Hulbert puts it “just lucky.”
2. Luck Versus Skill in the Cross Section of Mutual Fund Returns, Fama, Eugene F. and French, Kenneth R., "Luck Versus Skill in the Cross Section of Mutual Fund Returns" (December 14, 2009). Tuck School of Business Working Paper No. 2009-56 ; Chicago Booth School of Business Research Paper; Journal of Finance, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1356021
Abstract: The aggregate portfolio of U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors. Bootstrap simulations suggest that few funds produce benchmark adjusted expected returns sufficient to cover their costs.
Abstract: We examine the selection and termination of investment management firms by 3,400 plan sponsors between 1994 and 2003. Plan sponsors hire investment managers after large positive excess returns but this return chasing behavior does not deliver positive excess returns thereafter. Investment managers are terminated for a variety of reasons, including but not limited to underperformance. Excess returns after terminations are typically indistinguishable from zero but in some cases positive. In a sample of round-trip firing and hiring decisions, we find that if plan sponsors had stayed with fired investment managers, their excess returns would be no different than those delivered by newly hired managers.
Arithmetic of Active Management, by Nobel
Laureate William Sharpe.
The case against active management is clearly and logically spelled out. Summary: Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management. Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.
5. Trading Is Hazardous to Wealth: The Common Investment Performance of Individual Investors, Barber, Brad M. and Odean, Terrance, "Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors." Available at SSRN: http://ssrn.com/abstract=219228 or doi:10.2139/ssrn.219228
Abstract: This is an exhaustive study of 66,465 individual trading accounts, by Terrance Odean and Brad Barber. It should cure the investor of any desires to trade their own account. From 1991 to 1996, those 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 [indexed] investment strategies. Overconfident investors will overestimate the value of their private information, causing them to trade too actively and to earn below-average returns. The average household underperformed a risk adjusted benchmark by 3.7% annually, before the additional cost of federal and state taxes. The top twenty percent of active investors underperformed by 5.5%.
The results of individuals are remarkably similar to mutual funds, which also underperform a simple market index (Jensen 1969). Mutual funds trade often and trading hurts their performance (Carhart 1997). Carhart's conclusion: The results do not support the existence of skilled or informed mutual fund portfolio managers.
6. Returns from Investing in Equity Mutual Funds 1971-1991, Malkiel, Burton G. G., "Returns from Investing in Equity Mutual Funds" 1971-1991. JOURNAL OF FINANCE, Vol 50 No 2, June 1995. Available at SSRN: http://ssrn.com/abstract=6119
Abstract: This study utilizes a unique data set including returns from all equity mutual funds existing each year. These data enable us more precisely to examine performance and the extent of survivorship bias. In the aggregate, funds have under performed benchmark portfolios both after management expenses and even gross of expenses. Survivorship bias appears to be more important than other studies have estimated. Moreover, while considerable performance persistence existed during the 1970s, there was no consistency in fund returns during the 1980s.
7. The Performance of Mutual Funds in the Period 1945-1964, Jensen, Michael C., "The Performance of Mutual Funds in the Period 1945-1964." Journal of Finance, Vol. 23, No. 2, pp. 389-416, 1967. Available at SSRN: http://ssrn.com/abstract=244153 or doi:10.2139/ssrn.244153
Abstract: In this paper I derive a risk-adjusted measure of portfolio performance (now known as Jensen's Alpha) that estimates how much a manager's forecasting ability contributes to the fund's returns. The measure is based on the theory of the pricing of capital assets by Sharpe (1964), Lintner (1965a) and Treynor (Undated). I apply the measure to estimate the predictive ability of 115 mutual fund managers in the period 1945-1964 - that is their ability to earn returns which are higher than those we would expect given the level of risk of each of the portfolios.
The evidence on mutual fund performance indicates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance. It is also important to note that these conclusions hold even when we measure the fund returns gross of management expenses (that is assume their bookkeeping, research, and other expenses except brokerage commissions were obtained free). Thus on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses.
8. The Persistence of Risk-Adjusted Mutual Fund Performance, Elton, Edwin J., Gruber, Martin J. and Blake, Christopher R., "The Persistence of Risk-Adjusted Mutual Fund Performance" (May 1995). NYU Working Paper No. FIN-95-018. Available at SSRN: http://ssrn.com/abstract=1298325
Abstract: There is overwhelming evidence that, post expenses, mutual fund managers on average underperform a combination of passive portfolios of similar risk. The recent increase in the number and types of index funds that are available to individual investors makes this a matter of practical as well as theoretical significance. Numerous index funds, which track the S&P 500 index or various small-stock, bond, value, growth, or international indexes, are now widely available to individual investors. These same choices have been available to institutional investors for some time. Given that there are sufficient index funds to span most investors risk choices, that the index funds are available at low cost, and that the low cost of index funds means that a combination of index funds is likely to outperform an active fund of similar risk, the question is, why select an actively managed fund?
In another study mentioned in Asset Management: Active versus Passive Management, by Rex Sinquefield (listen to the actual debate here), Elton, Gruber,
Hlavka and Das studied all 143 Equity Mutual Funds that
survived from 1965-1984. These funds were compared to a
set of index funds 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
underperform the index funds by a whopping 1.6% per year,
before federal and state taxes. Not a single fund generated
a positive performance that was statistically significant.
9. On Persistence in Mutual Fund Performance, Carhart, Mark M., "On Persistence in Mutual Fund Performance." JOURNAL OF FINANCE, Vol. 52 No. 1, March 1997. Available at SSRN: http://ssrn.com/abstract=8036
Abstract: Using a sample free of survivor bias, I demonstrate that common factors in stock returns and investment expenses almost completely explain persistence in equity mutual funds' mean and risk-adjusted returns. Hendricks, Patel and Zeckhauser's (1993) "hot hands" result is mostly driven by the one-year momentum effect of Jegadeesh and Titman (1993), but individual funds do not earn higher returns from following the momentum strategy in stocks. The only significant persistence not explained is concentrated in strong underperformance by the worst-return mutual funds. The results do not support the existence of skilled or informed mutual fund portfolio managers. The comprehensive study looked at 1,892 funds that existed in any period between 1961 and 1993. The result: Carhart 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.
10. Fundamental Economic Variables, Expected Returns, and Bond Fund Performance, Elton, Edwin J., Gruber, Martin J. and Blake, Christopher R., "Fundamental Economic Variables, Expected Returns, and Bond Fund Performance." JOURNAL OF FINANCE, Vol. 50 No. 4, September 1995. Available at SSRN: http://ssrn.com/abstract=6820
The first major study of bonds funds, Blake, Elton, and Gruber examined 361 bonds 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. Abstract: In this paper, we develop relative-pricing (APT) models that are successful in explaining expected returns in the bond market. We utilize indexes as well as unanticipated changes in economic variables as factors driving security returns. An innovation in this paper is the measurement of the economic factors as changes in forecasts. The return indexes are the most important variables in explaining the time series of returns. However, the addition of the economic variables leads to a large improvement in explaining the cross-section of expected returns. We utilize our relative-pricing models to examine the performance of bond funds.
11. Prophets and Losses: Reassessing the Returns to Analysts' Stock Recommendations, Barber, Brad M., Lehavy, Reuven, McNichols, Maureen F. and Trueman, Brett, "Prophets and Losses: Reassessing the Returns to Analysts' Stock Recommendations" (May 2001). Available at SSRN: http://ssrn.com/abstract=269119 or doi:10.2139/ssrn.269119
Abstract: After a string of years in which security analysts' top stock picks significantly outperformed their pans, the year 2000 was a disaster. During that year the stocks least favorably recommended by analysts earned an annualized market-adjusted return of 48.66 percent while the stocks most highly recommended fell 31.20 percent, a return difference of almost 80 percentage points. This pattern prevailed during most months of 2000, regardless of whether the market was rising or falling, and was observed for both tech and non-tech stocks. While we cannot conclude that the 2000 results are necessarily driven by an increased emphasis on investment banking by analysts, our findings should add to the debate over the usefulness of analysts' stock recommendations to investors. Security Analysts may be the ultimate stock pickers.
12. Too Many Cooks Spoil the Profits: Investment Club Performance, Barber, Brad M. and Odean, Terrance, "Too Many Cooks Spoil the Profits: Investment Club Performance." Available at SSRN: http://ssrn.com/abstract=219188 or doi:10.2139/ssrn.219188
Abstract: The financial press makes frequent and bold claims regarding the performance of investment clubs. One oft quoted figure from a National Association of Investment Club survey states that 60 percent of investment clubs beat the market. Are these claims myth or reality? We analyze the common stock investment performance of 166 investment clubs using account data from a large discount broker from February 1991 to January 1997. We document that the average club earned an annualized geometric mean return of 14.1 percent, while a market index returned 17.9 percent. In addition, 60 percent of the clubs we analyze underperform the index. Not only did the average club fail to beat the market, it failed to match the performance of the average individual investor, who earned 16.4 percent during our sample period.
There are two reasons for the poor performance of investment clubs relative to individuals during our sample period -- trading costs and investment style. Despite having roughly similar account sizes, clubs execute smaller trades and hold more stocks than do individuals. Thus their proportionate cost of trading is higher. These higher proportionate trading costs account for approximately one-third of the clubs performance shortfall relative to individuals. The remaining two-thirds of the shortfall are accounted for by investment style. Relative to individuals, clubs tilt more toward large stocks and growth stocks. Investment clubs serve many useful functions: They encourage savings. They educate their members about financial matters. They foster friendships and social ties. They entertain. Unfortunately, their investments do not beat the market.
2002 study by Dimensional Fund Advisors looked at 44 institutional pension plans
with $425 billion in total assets. They found that when the
returns were properly risk adjusted using the Fama French
Three-Factor model, 96% of the returns were explained by
the three risk factors, and the value added
by active management was statistically insignificant.
15. Hedge Funds: Risk and Return, Malkiel, Burton G. G. and Saha, Atanu, "Hedge Funds: Risk and Return." Financial Analysts Journal, Vol. 61, No. 6, pp. 80-88, November/December 2005. Available at SSRN: http://ssrn.com/abstract=872868
Abstract: Constructing a data base that is relatively free of bias, this paper provides adjusted measures of the returns and risk of hedge funds. We also examine the substantial attrition of hedge funds and analyze the determinants of hedge fund survival as well as perform tests of return persistence. Finally, we examine the claims of the managers of “funds of funds” that they can form portfolios of “the best” hedge funds and that such funds provide useful instruments for individual investors. We conclude that hedge funds are far riskier and provide much lower returns than is commonly supposed.
16. Reflections on the Efficient Market Hypothesis: 30 Years Later, Malkiel, Burton G. G., "Reflections on the Efficient Market Hypothesis: 30 Years Later." Financial Review, Vol. 40, No. 1, February 2005. Available at SSRN: http://ssrn.com/abstract=622883
Abstract: The evidence is overwhelming that active equity management is, in the words of Ellis (1998), a "loser's game." Switching from security to security accomplishes nothing but to increase transactions costs and harm performance. Thus, even if markets are less than fully efficient, indexing is likely to produce higher rates of return than active portfolio management. The most successful modern-day investor, Warren Buffett, sums up the advice in this paper with characteristic wisdom: "Most investors, both institutional and individual, will find that the best way to own common stocks ... is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals."
17. Do you still want to try to pick stocks? If so, then you need to download these papers and read them. Still not satisfied? Then go to the "Academic Papers" section and review the additional papers there. If you still want to pick stocks, then you need to visit a Gamblers Anonymous Recovery Program.
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