Wall Street's Biggest Con
Say you get an email from a stockbroker saying he has come up with an algorithm that can predict the stock market. Over the next 10 days, all his predictions come true and he asks you to invest with him. Why wouldn’t you? This stockbroker has clearly found a way to beat the market. If you do give this broker money then you have fallen victim to one of the oldest scams in the book.[i]
Let’s look at this situation from the stock broker’s perspective. The stockbroker has been sending every combination of possible predictions to tens of thousands of other people, and you are one of the unlucky few who got 10 good ones in a row. He’s playing the numbers game. He may have started off with tens of thousands of people, but only a hundred or so people received the perfect predictions. Would you call this stockbroker skilled for getting 10 predictions in a row right? Absolutely not! This story applies to mutual funds and hedge funds as well.
One way mutual fund and hedge funds attract potential investors is through a presentation of their past performance. If they show that their managers have shown great historical performance, investors may be inclined to believe that these results will continue into the future. Investors must be wary though. Many fund houses have a tendency to drop poor performing funds, generally because of poor results or low asset accumulation. This results in an overestimation of past returns. [ii]
Mutual and hedge Funds employ “incubation periods” for their finest ideas. These ideas are initially funded in-house. The company lets them run for three years. Let’s say 17 don’t perform better than the benchmark, 1 matches the benchmark, and the last 2 perform spectacularly. These 2 will get pushed to external investors after the incubation period is over.[iii] The irony in this approach is that – while investors are attracted to past spectacular performance results – the truth is that none of this past performance was captured by a single external investor at all.
Skill vs. Luck
Many funds use devious methods to trick investors into thinking fund managers have skills to beat the market. However, what about glorified top hedge fund managers on Wall Street? They seem to consistently outperform the market and have gained a lot of fame from predicting market movements. How can their performance be attributed to luck if they are always beating the market? Let’s look at two examples:
Bill Miller was a famous manager at Legg Mason Value Trust. He ended up beating the S&P 500 for 15 straight years through 2005. At the time he was praised as a very skilled manager. Yet from 2006 until 2012 he ended up lagging behind a simple index fund.[iv] In fact he made a statement about his 15 year streak of good performance, “As for the so-called streak, that's an accident of the calendar. If the year ended on different months it wouldn't be there and at some point the mathematics will hit us. We've been lucky. Well, maybe it's not 100% luck—maybe 95% luck.”
A study done by Leonard Mlodinow, concluded that the odds of someone beating the market 15 years in a row at some point in modern US investing is around 75%.[v] Thus, it actually would have been odd if someone hadn’t achieved this feat.
Meredith Whitney became popular and admired on Wall Street when she successfully forecasted the difficulties of Citigroup and other major banks in the financial crisis of 2008. With her newfound fame, she went on to start a hedge fund, Kenbelle Capital. After a few years of poor performance, the hedge fund was shut down recently. That’s because most investment success is due overwhelmingly to luck rather than skill.[vi]
So just how much does investment skill affect performance? UCLA finance professor Brad Cornell has proposed a simple formula for gauging the relative investment importance of skill and luck. Upon applying that formula to a large sample of mutual funds, he found that 92% of the differences in those funds’ annual returns were “attributable to random chance.” When Cornell’s formula was applied to several hundred investment advisors the result was the same. Top-ranked performance is rarely repeated the next year.[vii] If you’re an advisor who has made a great call or has an ongoing hot streak, market the heck out of your track record before your hand inevitably cools. If, on the other hand, you are an investor, please keep in mind that the adviser with this stellar track record was just lucky, not genuinely skilled!
So What Can You Do As An Investor?
From this article you can see that outperformance with active managers mostly consists of luck. There are several things you can do to outperform most active managers over a long time horizon. Although it is not the most flashy and fun way to invest money, it is the safest in terms of performing at your benchmark.
Invest in low cost ETFs and Index Funds
ETFs and Index Funds are a cheap, passive way to diversify your portfolio and track an index.
Rebalance your portfolio annually. This is also an opportunity to update your portfolio according to your goals. Maybe you want to switch to more fixed income funds as you get older.
Diversify your portfolio according to your characteristics
Use funds that match your risk profile, your time horizon, and your currency.
If you follow these steps you’ll perform better than 90% of active investment managers over a long time horizon such as 8-10 years and your winning odds increase the longer you hold your investments beyond 10 years. The next time you hear that someone has the next breakthrough method to beat the market, ignore it. Keep the peace of mind that although you won’t outperform everyone, you’ll still have better returns than the majority of active managers.
Skill is still worth something for investment managers. It makes up around 8% of investment returns. However, that is pretty insignificant. For example, take a card counter playing Blackjack. If he’s skilled at counting cards he can push the odds slightly in his favor. He knows when to fold, hit, and double down based on probabilities. Yet, his performance is ultimately based on luck. He might be able to balance the odds in his favor after playing hundreds, if not thousands of rounds. However, rounds in the investment world last months, if not years.[viii] The skill portion of investment management may take a lot of time to produce valuable returns and are difficult to predict ex ante. In the investing world, patience is not a quality most people have. A couple of consecutive periods of underperformance are a death sentence to funds. The safest way to ensure you perform as well as a benchmark is through evidence-based low-cost index fund investing.
[iii] Swedroe, Larry E. The Quest for Alpha. Hoboken: John Wiley & Sons Inc., 2011.