If markets do a good job of pricing securities, you should expect managers who focus on finding pricing "mistakes" to struggle.
A study by Dimensional Fund Advisors confirms this principle, showing that most fund managers underperform their benchmarks. The results suggest that investors are best served by relying on market prices.
A test of market prices
The global financial markets process millions of trades worth hundreds of billions of dollars each day.
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These trades reflect the viewpoints of buyers and sellers who are investing their capital. Using these trades as inputs, the market functions as a powerful information-processing mechanism, aggregating vast amounts of dispersed information into prices and driving them toward fair value. Investors who attempt to outguess prices are pitting their knowledge against the collective wisdom of all market participants.
So, are investors better off relying on market prices or searching for mispriced securities?
Managed fund industry performance offers one test of the market's pricing power.
If markets do not effectively incorporate information into securities prices, then opportunities may arise for professional managers to identify pricing "mistakes" and convert them into higher returns. In this scenario, we might expect to see many managed funds outperforming benchmarks.
But the evidence suggests otherwise.
Across thousands of funds covering a broad range of manager philosophies, objectives, and styles, a majority of the funds evaluated did not outperform benchmarks after costs. These findings suggest that investors can rely on market prices.
Survivorship and Outperformance
The size of the managed fund landscape can obscure the fact that many funds disappear each year, often due to poor investment performance.
Investors may be surprised by how many managed funds disappear over time. More than half of the equity and fixed income funds were no longer available after 20 years.
Including these non-surviving funds in the sample is an important part of assessing managed fund performance because it offers a more complete view of the fund universe and possible outcomes at the time of fund selection.
The evidence suggests that only a low percentage of funds in the original sample were "winners"—defined as those that both survived and outperformed benchmarks.
The Search for Persistence
Some investors select managed funds based only on past returns. But sometimes good track records happen by chance, and short-term outperformance fails to repeat.
The data shows that among funds ranked in the top quartile (25 per cent) based on previous five-year returns, a minority also ranked in the top quartile of returns over the following five-year period.
This lack of persistence casts further doubts on the ability of managers to consistently gain an informational advantage on the market.
Some fund managers might be better than others but track records alone may not provide enough insight to identify management skill. Stock and bond returns contain a lot of noise, and impressive track records may result from good luck. The assumption that strong past performance will continue often proves faulty, leaving many investors disappointed.
The performance of US-domiciled managed funds illustrates the power of market prices. For the consecutive five-year periods examined, the research shows that:
Outperforming funds were in the minority .
Strong track records failed to persist.
The results of this study suggest that investors are best served by relying on market prices. Investment methods based on a manager's ability to outguess market prices have resulted in underperformance for the vast majority of managed funds.
We believe the research highlights an important investment principle: The capital markets do a good job of pricing securities, which intensifies a fund's challenge to beat its benchmark and other market participants.
Despite the evidence, many investors continue searching for winning managed funds and look to past performance as the main criterion for evaluating a manager's future potential.
Choosing a long-term winner involves more than seeking out funds with a successful track record, as past performance offers no guarantee of a successful investment outcome in the future. Moreover, looking at past performance is only one way to evaluate a manager.
In the end, investors should consider other aspects of a managed fund—such as underlying market philosophy and robustness in portfolio design—which are important to delivering a good investment experience and, ultimately, helping investors achieve their goals.
Nick Stewart is an Authorised Financial Advisers and CEO at Stewart Group, A Hawke's Bay-based CEFEX certified financial planning and advisory firm. Stewart Group provides personal fiduciary services, Wealth Management, Risk Insurance & KiwiSaver solutions.
This article is prepared in association with Dimensional Fund Advisors. The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961 or visit our website, www.stewartgroup.co.nz