You can’t blame fund managers for taking the credit for outperformance. After all, as only around 1% of them beat the market with any degree of regularity, they rarely have the opportunity. It’s natural, too, that most financial advisers ascribe strong returns to managers’ expertise; they’ve built their business models on their ability to pick the best funds. Journalists too are predisposed to emphasise skill; star managers make great copy, quite apart from the advertising revenue they generate.
In reality, though, much of what passes as skill in fund management actually isn’t. With around 200,000 active managers in the world, you’d expect there to be winners by the law of averages. In fact, rather fewer funds outperform consistently than you’d expect by random chance. Luck undoubtedly plays a part in outperformance, though precisely how much of a part it’s difficult to calculate.
But there is another explanation for outperformance that’s often overlooked, and it’s this. Many managers who have beaten the market over the long term have done so simply by tilting their funds towards the different risk factors that are known to deliver higher returns.
As Eugene Fama and Kenneth French demonstrated in 1992, small-cap and value stocks have historically outperformed large and growth stocks, albeit with a greater degree of volatility. So, by increasing their exposure to small-cap and value, managers can deliver higher returns over time in exchange for a bumpier ride along the way.
In the UK, for example, the average five-year returns of active managers appear slightly better than those of their peers in the US or in France and Germany. The reason for that is the FTSE 100 is dominated by a small number of very large stocks, so UK managers have naturally tended to tilt towards smaller companies.
Of course, active managers are perfectly entitled to move up or down the cap scale, or invest in another asset classes altogether; typically the small print allows them to invest up to 30% of the fund in something completely different. But, for example, a large-cap fund with a 25% holding in small- and-mid-caps should not be compared to a large-cap index.
The same applies to active funds that tilt towards value stocks. There was a lively spat in the US recently between the investment author Larry Swedroe and David Barse, CEO of Third Avenue management. In a debate with Swedroe on Bloomberg, Barse claimed that Third Avenue was beating its benchmark index.
But when Swedroe took a closer look, he found that the proper benchmarks to which the returns of Third Avenue funds should be compared “are not market-like indexes (such as the S&P 500). Instead, they should be compared to value indexes. Or better yet, to comparable passively managed value funds (which also possess costs and trading expenses) in the same asset classes.”
Swedroe then analyzed Third Avenue’s returns in three different sectors, and discovered that, when compared to the correct benchmarks, their funds were actually underperforming by large margins.
Nor is this tendency to equate factor tilts with skill confined to equity funds. To quote Morningstar researcher Alex Bryan, “fixed-income managers can — and often do — boost returns by taking more credit or interest-rate risk than their benchmarks, but that does not necessarily require skill. Investors can do that on their own with low-cost index funds, so it is hard to justify paying high fees for performance that is simply compensation for risk. And while risk taking can pay off in one period, it may lead to underperformance in another.”
Of course, none of this means there are no skilled managers out there. There are, but they’re very few in number, they’re almost impossible to identify in advance and, even if you’re lucky enough to pick one before they start to outperform, their fees are likely to cancel out much, if not all, of any value they add.
The easiest, cheapest and most efficient way to invest is via a highly diversified portfolio of index funds. For the majority of investors this should include tilting towards the different factors proven to generate higher returns. That’s nothing to do with skill; it’s just evidence-based investing.