Underlying Academic Papers: Markowitz, 1952; Sharpe, 1964; Brinson, Hood & Beebower, 1986; Brinson, Singer & Beebower, 1991; Ibbotson & Kaplan, 2000
- Actively managed funds return a lot less than passively managed funds
- Past outperformance by an actively managed fund gives no assurance that they will continue to do so in the future
- A low management fee is the biggest predictor if a fund will perform well
- Selecting an appropriate combination of stocks and bonds better predicts performance than investment selection
- Stock are inherently more risky than bonds, but historically have had a higher return
Note: This article is more in-depth than typical articles and does us some financial language. However, if you’re feeling up to the task, I highly recommend reading and reading to make sure you understand each point.
Fortunately, some of the smartest people (see underlying academic papers above) in the world have dedicated their life’s work to determining how best to go about investing and made their conclusions based off 50+ years of historical investment data. These landmark papers have compared the investment returns of actively managed funds (think mutual funds and hedge funds) to those of unmanaged benchmarks (think of the S&P 500 or the NASDAQ). And based of these comparisons they have concluded the following:
- The average actively managed fund has had a lower return than comparable benchmark’s return (as much as 2.55% a year over a 15 year time frame!)
- The comparison was even worse when accounting for survivorship bias – meaning the funds that don’t perform and are shut down are still taken into account
- Persistence of performance among past winners is no more predictable than a coin flip
The theory underpinning why this is the case is called the ‘zero-sum game’. It states that all of the holdings of investors collectively form the market and that the average performance of the market is just the average of the return of each investor. Therefore, if one investor outperforms the market, another investors is on the opposite side of the trade and is underperforming relative to the market.
To really drive the concept home, let’s try to visualize it. So the diagram below represents all of the returns of every single investor (creating a bell curve) with the center being the markets return of 6%.
So investors are continuously ‘dropping out’ of the active investing game and merely buying indexes to track the market and receive a 6% return (in this case). This continuous loss of underperforming investors causes the sophisticated outperforming investors to have to compete with each other and end up on the underperforming side of the equation from time to time.
The next thing to factor in is the management fee that active fund managers typically charge, typically ranging from 0.50% to 2.00%. These fees automatically handicap them and force them to not only match the markets return (which is difficult by itself) but beat it by more than their management fee. Take the example below with a 1.00% management fee:
These facts have even lead Warren Buffet, one of the best (if not the best) active fund managers in the world, to tell his heirs to put his estate (valued in the billions) into low-cost passive index funds.
“If you can’t find the needle, buy the haystack”
The researchers determined that selecting an appropriate asset allocation is more important than selecting the individual funds that you invest in. In fact, research from Vanguard has determined that 88% of a portfolios return can be example only be asset allocation, with the remaining 12% determined by investment selection and market-timing (assuming a diversified portfolio).
Decades of research have shown that stocks are inherently more risky than bonds. So when figuring out how to invest your portfolio the first thing to determine is how much risk you are able and willing to accept. Vanguard has put together a very useful historical volatility calculator to show you how a portfolio with varying levels of stocks and bonds would have performed since 1926.
Since stocks are inherently more risky than bonds, investors demand a higher return from them. Otherwise investors would only invest in a less risky assets with higher returns. So the general concept is:
Less Risk = Less Return