More than 80% of Australian fund managers have underperformed the index over 15 years, according to the latest S&P Indices Versus Active Funds (SPIVA) Report. The results are even worse in the US where 92% have delivered lower returns than the S&P 500 index.
The report found that “81.2%, 78.2% and 83.6% of funds underperforming the S&P/ASX 200 over the 5-, 10- and 15-year horizons, respectively.”
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 less than half of active fund managers beat the index. However, this number dwindles as time goes on.
This is why over five years just 5% of funds were able to beat the index, when it came to investing into international shares. Overall, just 43% of funds “survived” over a 15-year period with the rest merging or shutting down.
Our Fat Cat Funds Report finds similar results each year with the majority of superannuation funds in Australia underperforming their benchmarks. Our own research into active managed funds also found that between 76% and 97% of funds underperform a simple index ETF.
The paradox of skill
You might think that active managers must be throwing darts to get such poor results! However, even with access to the latest technology, their rates of return have not improved.
It’s not that active managers aren’t smart. The opposite is actually true. They are some of the smartest people. And with so many smart people working in finance, it actually gets harder and harder for all of them to beat the market.
Coupled with their fees (that cover wages, bonuses, overheads) and it’s obvious why most active fund managers simply cannot and will not beat a simple index over the long-term.
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 and 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.
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 in fees, the less returns 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.
