The statement that a money manager or broker cannot, with consistency, outperform “the market” is cause for a fight with most Wall Street types. So, I guess the first thing we should do is ask and answer, “Is this true that money managers cannot consistently outperform “the market”?

Let’s begin with some factual data and the word of some recognized authoritative experts.

First, Standard & Poors: “Over the five year market cycle from 2004 to 2008, S&P 500 outperformed 71.9% of actively managed large cap funds, S&P MidCap 400 outperformed 79.1% of mid cap funds and S&P SmallCap 600 outperformed 85.5% of small cap funds. These results are similar to that of the previous five year cycle from 1999 to 2003.”[1]

“After taking risk into account, do more managers than you’d see by chance outperform with persistence? Virtually every economist who studied this question answers with a resounding ‘no.’ Mike Jensen in the sixties and Mark Carhart in the nineties both conducted exhaustive studies of professional investors. They each conclude that in general a manager’s fee, and not his skill, plays the biggest role in performance.”

Eugene Fama, Jr.

“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.”

William Bernstein, The Intelligent Asset Allocator

“It turns out for all practical purposes there is no such thing as stock picking skill. It’s human nature to find patterns where there are none and to find skill where luck is a more likely explanation [particularly if you’re the lucky mutual fund manager]. Mutual fund manager performance does not persist and the return of stock picking is zero. We are looking at the proverbial bunch of chimpanzees throwing darts at the stock page. Their ‘success’ or ‘failure’ is a purely random affair.”

William Bernstein, The Intelligent Asset Allocator

“When some individual made a fortune in the stock market, we have a tendency to assume that was because he knew something, and of course the individual is happy to reinforce that belief – yes, I was a genius or I was very clever or I always said Microsoft was going to make me rich. But what you don’t see are the thousands, hundreds of thousands, perhaps millions of people who are going, ‘I always said that ABC Company was going to make me rich, and ABC Company went bust.’”

Professor Zvi Bodie, Boston University

“…skepticism about past returns is crucial. The truth is, as much as you may wish you could know which funds will be hot, you can’t – and neither can the legions of advisers and publications that claim they can. That’s why building a portfolio around index funds isn’t really settling for average.  It’s just refusing to believe in magic.”

Bethany McLean, Fortune

“Economic evidence shows that, from a typical investment perspective, the major capital markets of this country are highly efficient, in the sense that available information is rapidly digested and reflected in the market prices of securities. As a result, fiduciaries and other investors are confronted with potent evidence that the application of expertise, investigation, and diligence in efforts to “beat the market” in these publicly traded securities ordinarily promises little or no payoff, or even a negative payoff after taking account of research and transaction costs. Empirical research supporting the theory of efficient markets reveals that in such markets skilled professionals have rarely been able to identify under-priced securities (that is, to outguess the market with respect to future return) with any regularity. In fact, evidence shows that there is little correlation between fund managers’ earlier successes and their ability to produce above-market returns in subsequent periods.”

Restatement of Trusts [Third] §227 General Note on Comments e through h:
Introduction to Portfolio Theory and Other Investment Concepts

From current data, from academics, from journalists and from legal scholars, it is concluded that money managers cannot, with consistency, outperform the market. In another article we will discuss what one should do about this stubborn fact.

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[1] Standard & Poor’s Indices Versus Active Funds Scorecard (SPIVA), Year End 2008, April 20, 2009

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