Efficient Markets

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© Brendan Ross

Active management is a zero sum game

It’s a good idea for people to keep in mind that active management must, as a whole, do worse than passive management.  This is a mathematical certainty, because all stocks must be owned by someone.  There must be a loser for every winner, in every transaction.  Since active management incurs more costs than passive management, its certain that on average active management must do worse.  The results show this to be the case.

The average investor is below average

Of course no investor likes to believe that he or she is average, or that he or she would pick average stocks or mutual funds.  Ironically, they’re right:  most investors end up with below average returns, since the active funds they choose incur fees and are beaten out by index funds.  We address this more in other articles.

Nobel Prize winning economists have contributed to the three components of efficient market theory:

  1. Random Walk – Prices in the market fluctuate randomly, with news being the driver of price changes.  News is inherently unpredictable.
  2. Efficient Markets – The current price in the stock market is the “correct price”, incorporating all currently available information.  There is no systematic way to find good deals in the markets.
  3. Modern Portfolio Theory – A correctly constructed portfolio will maximize return for a given degree of risk.  Typically this requires diversification both within and across asset classes.

A simpler way to restate these theories:

  • Nobody can time the markets and win
  • Nobody can pick individual stocks and win
  • If you want to keep your portfolio’s random up-and-down movements to a minimum, you’ll have to be very diversified

Every day thousands of traders with years of experience do their best to disprove these theories.  Every day their actions are recorded in what is perhaps the greatest ongoing experiment that the world has ever known.

All of this data is readily available, usually for a modest fee, to anyone with a penchant for primary statistical research.  CRSP, the Center for Research in Security Prices at the Chicago school of business is a good source.

Academic article:  Persistence in overformance is luck not skill

Here are selected quotes from a famous study of mutual fund performance by Mark Carhart called  “On Persistence in Mutual Fund Performance” (Journal of Finance, March 1997).  Carhart uses data from 1962 to 1993.  This article is cited by 163 other academic articles, placing it in the top 1% of all articles on economics.

  • “Persistence in mutual fund performance does not reflect superior stock-picking skill.  Rather, common factors in stock returns and persistent differences in mutual fund expenses and transaction costs explain almost all of the predictability in mutual fund returns. Only the strong, persistent underperformance by the worst-return mutual funds remains anomalous.”
  • “…funds that earn higher one-year returns do so not because fund managers successfully follow momentum strategies, but because some mutual funds happen by chance to hold relatively larger positions in last year’s winning stocks.  Hot-hands funds infrequently repeat their abnormal performance.”
  • “…individual mutual funds that appear to follow this one year momentum strategy earn significantly lower abnormal returns after expenses.  Thus, I conclude that transaction costs consume the gains from following a momentum strategy in stocks.”
  • “I demonstrate that expenses have at least a one-for-one negative impact on fund performance, and that turnover also negatively impacts performance.  By my estimates, trading reduces performance by approximately 0.95 percent of the trade’s market value.”
  • “Thus, the best past-performance funds appear to earn back their expenses and transaction costs even though the majority underperform by approximately their investment costs.”
  • “By December 31, 1993, about one-third of the total funds in my sample had ceased operations, so a sizeable portion of the database in not observable in most commercially available mutual fund databases.”
  • “…the funds in the top decile differ substantially each year, with more than 80% annual turnover in composition.  In addition, last year’s winners frequently become next year’s losers and vice versa, which is consistent with gambling behavior by mutual funds.”
  • “Overall, the evidence is consistent with market efficiency, interpretations of the size, book-to-market, and momentum factors notwithstanding.  Although the top-decile mutual funds earn back their investment costs, most funds underperform by about the magnitude of their investment expenses.”

The theme throughout this article is that the best funds, over long periods, do just enough better than their fellows to pay for their management fees.  Not exactly a glowing recommendation for actively managed mutual funds.

Performance is no better than a coin flip

Another interesting proof point comes from a study by SEI investments that is referenced in Swedroe’s book:

 Active Managers vs S&P500

As Morningstar and others will attest, there are many funds that have outperformed market indices for any given historical time period.  This graph is evidence that these results resemble pure luck.

With so many funds, some will get lucky

In 2004 there were 55,000 mutual funds worldwide, including 8,000 in the United States.  There is a 1.1% chance of getting either 9 or 10 heads in a series of 10 coin flips.  We’re sure you can imagine that the top 1.1% of mutual funds will have significantly outperformed the market.

Can you remain rational?

Imagine yourself scrolling down this long list of funds, all sorted by “performance in the last 3 years”.  You see page after page of funds that have outperformed the S&P 500.  You’d have to scroll through hundreds of funds before getting to the S&P 500 index.  Are you able to remain rational, and to conclude that what you are looking at is NO DIFFERENT than what you’d expect from the flipping of coins?  Most people cannot.  Greed and envy squash rationality and shove it aside.  Wall Street is well aware of this flaw in the human condition.

Who cares, you say!  Just because the graph looks like coin flips doesn’t mean that fund success is truly random.  There are plenty of funds that have outperformed over long periods, and their performance is hardly likely to fail just because you’re climbing aboard.  The folks who chose the funds that are forever on the left are just fools.  Funds couldn’t possibly move at random from high to low performance, never mind what Mark Carhart says!

Can anyone predict which actively-managed funds will be on the right side of this graph next year?