Financial Gurus and Other Fantastic Creatures

Welcome to the next installment in Escient Financial’s series on Evidence-Based Investment Insights: Financial Gurus and Other Fantastic Creatures.

The last piece in this series, “Ignoring the Siren Song of Daily Market Pricing,” explored how price-setting occurs in capital markets, and why investors should avoid reacting to breaking news. The cost and competition hurdles are just too tall. Now it's time to explain why you’re also ill-advised to seek a pinch-hitting expert to compete for you.

In his Berkshire Hathaway 2017 Shareholders Letter, Warren Buffett described his take on investment “experts” when he wrote: “Performance comes, performance goes. Fees never falter.”

Instead, Buffett suggests, “Seizing the opportunities then offered does not require great intelligence, a degree in economics, or a familiarity with every bit of Wall Street jargon. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals.”

Group Intelligence Wins Again

As was covered in “You, the Market, and the Prices You Pay,” independently thinking groups (like capital markets) are better at arriving at accurate answers than even the smartest individuals in the group. That’s in part because their wisdom is already bundled into prices, which adjust with fierce speed and relative accuracy to any new, unanticipated news.

Thus, even experts who specialize in analyzing business, economic, geopolitical, or any other market-related information face the same challenges you do if they try to beat the market by successfully predicting an uncertain reaction to unexpected news that is not yet known. For them too, particularly after costs, group intelligence remains a prohibitively tall hurdle to overcome.

The Proof is in the Pudding

But maybe you know of an extraordinary stock broker or fund manager or TV personality who strikes you as being among the elite few who can make the leap. Maybe they have a stellar track record, impeccable credentials, a secret sauce, or brand-name recognition. Should you turn to them for the latest market tips, instead of settling for “average” returns?

Let’s set aside market theory for a moment and consider what has actually been working. Bottom line, if investors who did their homework were able to depend on outperforming experts, we should expect to see credible evidence of it.

To cite one of many sources, Morningstar publishes a semiannual Active/Passive Barometer report, comparing actively managed funds to their passively managed peers. In its most recent, August 2020 report, Morningstar found: “In general, actively managed funds have failed to survive and beat their benchmarks, especially over longer time horizons; only 24% of all active funds topped their average passive rival over the 10-year period ended June 2020.”

The disappointment isn’t limited to U.S. markets, either. Morningstar produces a similar, semiannual European Active/Passive Barometer, in which it reached similar conclusions (emphasis ours): “European stock-pickers’ long-term success rates are low. Over the 10 years through June 2020, the active manager success rate was less than 25% in nearly two thirds of the categories surveyed.”

Across the decades and around the world, a multitude of academic studies have scrutinized active manager performance and consistently found it lacking.

• Among the earliest such studies is Michael Jensen’s 1967 paper, “The Performance of Mutual Funds in the Period 1945–1964.” He concluded, there was “very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.”
• More recently, Eugene Fama and Kenneth French published a 2010 Journal of Finance study, “Luck Versus Skill in the Cross Section of Mutual Fund Returns,” demonstrating that “the high costs of active management show up intact as lower returns to investors.”
• In the decades between and since, there have been dozens of similar studies published by these and other academic luminaries. In 2016, a pair of professors from the University of North Florida published “A Review of Studies in Mutual Fund Performance, Timing and Persistence,” scrutinizing more than 60 of the “more widely cited works.” They concluded: “The basic results have not changed; it appears that: (1) mutual funds underperform the “market;” (2) fund managers in aggregate are incapable of timing the market; and (3) mutual fund investors are ill-advised to invest based on prior fund performance.”

Lest you think hedge fund managers and similar experts can fare better in their more rarified environments, the evidence dispels that notion as well. For example, financial author Larry Swedroe provides an ongoing hedge fund performance update on ETF.com. In April 2019, he reported, “over the 10-year period ending 2018, [hedge funds] underperformed every single major equity asset class by wide margins.” Even for hedge funds, Swedroe suggests “the efficiency of the market, as well as the cost of the effort” are too tough to consistently overcome.

Your Take-Home

So far, you've been reading about some of the investment foes you face. The good news is, there is a way to invest that enables you to nimbly sidestep rather than face such formidable foes, and simply let the market do what it does best on your behalf. In the next installment, you'll get an introduction to the strategies involved, and your many financial friends. First up, an exploration of what some have called the closest you’ll find to an investment free lunch: Diversification.

In the meantime, feel free to...