By LARRY SWEDROE
Despite volumes of research attesting to the meaninglessness of past returns, most investors (and personal-finance magazines) seek tomorrow’s winners among yesterday’s. Forget it. The truth is, much as you may wish you could know which funds will be hot, you can’t — and neither can the legions of advisers and publications that claim they can.
—Fortune, March 15, 1999
Barry Bonds was arguably the best baseball player of his era. No one would consider him to have been lucky to generate the statistics he produced because they are persistently so much better than those of other players.
What is important to understand is that his superior results were probably the result of small differences in skills.
Bonds was perhaps a bit stronger than most players (though some are stronger). His bat speed was probably slightly faster (though there are others whose bat speed might be just as fast or faster). His hand/eye coordination was also probably slightly superior (again, a few probably have similar skills). He was also one of the fastest runners in the game (though he was not that much faster than most, and others had superior speed).
The small differences in each of these categories (and perhaps others) is what allowed him to be perhaps the best player of his era.
An athlete’s competition is other individual athletes
What is important to understand is that Bonds’ competition is other individual players. In terms of individual skills, he was not stronger than every player. Nor was he faster than every player, and so on. The world of investing, however, presents a very different situation. The difference in the form of competition is why we do not see persistence of outperformance of investment managers. To understand this, we need to understand how securities markets set prices.
Dr Mark Rubinstein, professor of applied investment analysis at the Haas School of Business at the University of California at Berkeley, provided the following insight:
Each investor, using the market to serve his or her own self-interest, unwittingly makes prices reflect that investor’s information and analysis. It is as if the market were a huge, relatively low-cost, continuous polling mechanism that records the updated votes of millions of investors in continuously changing current prices. In light of this mechanism, for a single investor (in the absence of inside information) to believe that prices are significantly in error is almost always folly. Public information should already be embedded in prices.1
Rubinstein was making the point that the competition for an investment manager is not other individual investment managers. Instead, it is the collective wisdom of the market — economist Adam Smith’s famous “invisible hand”. It’s the same collective wisdom that prevents knowledgeable sports fans from exploiting the lack of knowledge of the casual fan when betting on sporting events. The competition was the market, not the skills of each individual participant.
Active managers compete against the entire market
The implication for investors, as author Ron Ross points out in The Unbeatable Market, is that: “The quest for market-beating strategy boils down to an information-processing contest. The entity you are competing against is the entire market and the accumulated information discovered by all the participants and reflected in prices.”2
Here is another way to think about the quest for superior investment performance: “The potential for self-cancellation shows why the game of investing is so different from, for example, chess, in which even a seemingly small advantage can lead to consistent victories. Investors implicitly lump the market with other arenas of competition in their experience.”3
Rex Sinquefield, former co-chairman of Dimensional Fund Advisors (DFA) who retired in 2005, put it this way: “Just because there are some investors smarter than others, that advantage will not show up. The market is too vast and too informationally efficient.”4
While the competition for Bonds is other individual players, the competition for investment managers is the entire market. It would be as if each time Bonds stepped up to the plate, he had to face a pitcher with the collective skills of Randy Johnson (fastball), Greg Maddux (control), Roger Clemens (split-finger pitch), Carl Hubbell (screwball), Bert Blyleven (curveball) and Gaylord Perry (spitball). If that had been the case, Bonds certainly would not have produced the same results.
Absolute skill versus relative skill
In the world of investing, the competition is indeed tough. 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. What is referred to as the “paradox of skill” means that even as skill level rises, luck can become more important in determining outcomes if the level of competition also rises.
Charles Ellis noted in a 2014 issue of the Financial Analysts Journal that “over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition. They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”
Legendary hedge funds, such as Renaissance Technologies, SAC Capital Advisors and D.E. Shaw, hire Ph.D. scientists, mathematicians and computer scientists. MBAs from top schools, such as Chicago, Wharton and MIT, flock to investment management armed with powerful computers and massive databases.
For example, Gerard O’Reilly, the chief executive officer of DFA, has a Ph.D. from Caltech in aeronautics and applied mathematics. Eduardo Repetto, the chief investment officer of Avantis Investors, has a Ph.D. from Caltech and worked there as a research scientist. And Andrew Berkin, the head of research at Bridgeway Capital Management, has a Caltech B.S. and University of Texas Ph.D. in physics, and is a winner of the NASA Software of the Year Award.
According to Ellis, the “unsurprising result” of this increase in skill is that “the increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them, particularly after covering costs and fees”.
Another problem for investors is that since today as much as 90 percent of the trading is done by institutional investors, it is difficult to think of a large enough group of likely individuals to exploit.
Understanding the true nature of the competition and the difficulty of achieving superior performance, Ralph Wanger, former chief investment officer of Liberty Wanger Asset Management and lead portfolio manager of the Liberty Acorn Fund concluded:
For professional investors like myself, a sense of humour is essential for another reason. We are very aware that we are competing not only against the market averages but also against one another. It’s an intense rivalry. We are each claiming, “The stocks in my fund today will perform better than what you own in your fund.” That implies we think we can predict the future, which is the occupation of charlatans. If you believe you or anyone else has a system that can predict the future of the stock market, the joke is on you.5
Active management is a negative-sum game
There is another important difference between sports and investing that explains the lack of persistence of superior investment performance. When Bonds was at the plate, he was engaged in a zero-sum game — either he won, or the pitcher did.
However, investment managers trying to outperform are not engaged in a zero-sum game. In their efforts to outperform the market, they incur significantly higher expenses than passive investors accepting market returns. Those costs are research expenses, other fund operating expenses, bid-offer spreads, commissions, market impact costs and taxes. It would be as if Bonds went up to the plate with a doughnut (a weight) on his bat while all other hitters had no such handicap.
The academic research on the subject of performance persistence is clear: There is little to no evidence of any persistent ability to outperform the market without taking on greater risk.
The conventional wisdom is that past performance is a good predictor of future performance. The reason why it is conventional wisdom is that it holds true in most endeavours, be it a sporting event or any other form of competition. The problem for investors who believe in conventional wisdom is that the nature of the competition in the investment arena is so different that conventional wisdom does not apply—what works in one paradigm does not necessarily work in another.
Peter Bernstein, consulting editor of the Journal of Portfolio Management and author of several highly regarded investment books, including Against the Gods and Capital Ideas, put it this way: “In the real world, investors seem to have great difficulty outperforming one another in any convincing or consistent fashion. Today’s hero is often tomorrow’s blockhead.”6
The moral of the tale
To avoid choosing the wrong investment strategy, one must understand the nature of the game. In the investment arena, large institutional investors dominate trading. Thus, they are the ones setting prices. Therefore, the competition is tough.
Making the game even more difficult is that the competition is not each individual institutional investor. Instead, it is the collective wisdom of all other participants. The competition is just too tough for any one investor to be able to persistently outperform.
1. Mark Rubinstein, Rational Markets: Yes or No? The Affirmative Case, Financial Analysts Journal (May-June 2001).
2. Ron Ross, The Unbeatable Market (Optimum Press, 2002), p. 57.
3. Rubinstein, Rational Markets: Yes or No? The Affirmative Case.
4. Raymond Fazzi, Going Their Own Way, Financial Advisor (March 2001).
5. Ralph Wanger, A Zebra in Lion Country (Simon & Schuster, 1997).
6. Peter Bernstein, Against the Gods (Wiley, 1996).
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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