The Paradox of Skill: Why active funds disappoint every year

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The latest data for active fund returns to mid 2018 doesn’t bode well for traditional active fund managers.

Standard & Poor’s (S&P) SPIVA report for mid 2018 reveals that over 80% of Australian fund managers have underperformed the index over 15 years. The results are even worse in the US where 92% have delivered lower returns than the S&P 500 index.

A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.
Burton Malkiel, A Random Walk Down Wall Street (1973)

Each year just under half of active fund managers beat the index. With each passing year it becomes harder for them to earn enough of a return to make up for the drag of high costs. This is why over 5 years just 15% of funds are able to beat the index. Fixed interest (bond) fund managers find it even harder with just 2% beating the US index since 2002! Meanwhile 50% of funds were merged or shut down over those 15 years.

Percentage of active fund managers beaten by the index according to S&P Dow Jones SPIVA

Shares

Region 1 year 5 year 10 year 15 year
US
(S&P 500)
63.1% 84.2% 89.5% 92.3%
Eurozone
(S&P Eurozone BMI)
73.7% 87.5% 88.0%
Australia*
(S&P/ASX 200)
57.6% 68.7% 71.4% 80.2%

Bonds

Region 1 year 5 year 10 year 15 year
US
(Barclays US Government Long)
96.4% 98.3% 95.2% 98.0%
Australia*
(S&P/ASX Australian Fixed Interest 0+ Index)
52.7% 66.0% 69.0% N/A

*Australian results to mid 2018, US and Europe to end 2017.

Our Fat Cat Funds Report finds similar results each year with the majority of superannuation funds in Australia underperforming their benchmarks.

The paradox of skill

You might think that active managers must be throwing darts to get such poor results!

The truth is that fund managers are actually getting better every year as more of them join the workforce and technology improves.

The paradox of skill is a concept which explains why luck (not skill) becomes a much bigger factor in separating the winners from the losers as a market becomes more competitive.

In the 1970s it was much easier to beat the market simply because there was much less competition. Nowadays there are tens of thousands of well-paid stock analysts, fund managers, hedge funds and quant traders paid to ensure that any market opportunity is discovered an exploited within seconds.

As more sophisticated investors have entered the share market, the capacity for anyone to consistently beat the market has shrunk to almost zero. Those who do beat the market over a few years tend to underperform over subsequent years.

S&P Dow Jones found only 2 of 715 US share funds stayed in the top 25% for 5 years in a row.

In their book The Incredibly Shrinking Alpha, Larry Swedroe and Andrew Berkin succinctly explained why active funds management is getting more and more difficult:

What so many people fail to comprehend is that in many forms of competition, such as chess, poker or investing, it is the relative level of skill that plays the more important role in determining outcomes, not the absolute level.

Financial services is filled with smart people who have trouble admitting this to themselves – that being smart alone doesn’t always translate into market-beating results. Especially when there are thousands of others just like them.

How can this make you a better investor?

The maths is simple: the total return your fund manager earns minus any fees they charge is the final return you get. The more you pay, the less you get!

Earning market-beating returns gets harder each year but costs are with you always. That’s why we recommend low cost index funds to our clients and focus on combining the right mix of investments and minimising fund manager fees by using ETFs.

Want to learn more?

Why you wont beat the share market (but many still try)

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Chris Brycki

Stockspot Founder and CEO