By Robert Klemkosky
There is a lot of money professionally managed in the developed world, trillions of dollars. This money is managed by independent money managers, mutual funds, hedge funds and other institutional money managers. One vital question or concern for anyone having money professionally managed is how well the manager performs. This may seem like a simple question, but the outcome is more complex.
Most money managers usually tell clients what their investment style is; growth versus value, and then by market value of a company’s stock, large cap, mid cap or small cap. Growth stocks are those companies that have superior investment opportunities and have revenues, earnings and cash growing at higher rates than the economy. Examples include Amazon and Google. Both have optimistic futures and investors have high expectations about the future.
Value stocks have lower expectations in terms of growth and include mature companies. Size is subjective, but large cap stocks have market valuations greater than $5 billion, midcap $1 billion to $5 billion and small cap less than $1 billion. Once a manager selects an investment style, he or she must also select a benchmark against which to compare and measure performance. This could be something like the S&P 500 or the KOSPI index. There are numerous benchmarks from which the manager can choose, but it should be related to the investment style.
So how do managers do? Not so well in countries with developed markets. For example, last year in the United States, 79 percent of large-cap mutual fund managers had returns less than the S&P 500 according to Morningstar, a firm that tracks and analyzes mutual fund performance. This was the worst performance by large-cap firms since 1997, but over most time periods, the average mutual fund manager does not beat their benchmark in terms of performance. Recent data from Lipper, another firm that tracks fund performance, shows that only 34.9 percent of U.K. equity funds beat their benchmark over the last decade and only 16.2 percent of bond funds. There is also recent evidence that hedge funds do not outperform their benchmarks, especially after adjusting for risk.
Why would this be so? It seems that if most money is professionally managed, on average half the money managers should be beaten by the benchmark and half should beat it. The expenses of running a fund relegate most to the beaten side. For actively managed funds, annual expenses run 1.40 percent per year on average. When the market has negative returns or slightly positive returns, like the S&P 500 in 2011, it becomes more difficult to beat the benchmark after expenses.
Even without factoring in costs, many are of the opinion that active money managers can’t consistently beat their benchmarks because markets are informationally efficient. This relates to the Efficient Market Hypothesis (EMH) that has been a point of controversy between academics and active money managers for decades.
The EMH assumes that there are a large number of competing profit-maximizing investors who analyze and value securities, each independently of others. As new information comes to the market randomly, security prices adjust so rapidly to reflect the new information that few investors have the opportunity to take advantage of the new information. So competition among investors results in security prices that reflect at least public, information.
This does not mean that market prices are always in equilibrium. Pricing errors can exist, but if they are truly random, there is an equal chance that the security is under- or overvalued at any point in time. No group of investors should be able to consistently find undervalued or overvalued securities, making it difficult to beat the market on a risk-adjusted basis.
How about non-public information? There is little doubt that if someone has access to material information not available to the public, they should be able to outperform the market benchmark. Being able to use non-public information would be deemed unfair to most investors, so most countries have rules and laws that prohibit using non-public information. Just as important as the rules and regulations is the enforcement of them. So corporate insiders cannot use or pass on to other investors material non-public information. In the U.S., the Securities and Exchange Commission arrests dozens each year for violating insider trading laws. The biggest one ever, the Galleon case, involved more than 20 people arrested and found guilty of using non-public information.
If you believe markets are informationally efficient and active money managers can’t beat their benchmark after expenses, how should you invest? Many have chosen a passive index product such as an indexed mutual fund or an exchange-traded fund that tracks the index related to your investment style. The annual expenses are a lot lower and the major non-market risk is tracking error, which means the fund performance deviates from the benchmark.
In the U.S., approximately one-third of professionally managed money is indexed. Many have accepted market efficiency. The trend is away from active management to passively indexed managed funds. Many active money managers don’t like this trend, but the burden of proof is still on them as to their ability to outperform a market benchmark.
Historically it hasn’t happened with only a few exceptions. Those exceptions become famous like Warren Buffett, George Soros, Peter Lynch and a handful of others. There have been many others who have faltered after beating the market for several years. Past performance unfortunately is no guarantee of future performance as is often pointed out.