By LARRY SWEDROE
For decades, academics and practitioners alike have been searching for evidence of star stock pickers — skilful money managers who genuinely add value. But they’ve had little success in finding persistence beyond the randomly expected. In their seminal 2004 paper, Mutual Fund Flows and Performance in Rational Markets, authors Jonathan Berk and Richard Green explain why it is hard to find persistent outperformance: “Investments with active managers do not outperform passive benchmarks because investors competitively supply funds to managers and there are decreasing returns for managers in deploying their superior ability. Managers increase the size of their funds, and their own compensation, to the point at which expected returns to investors are competitive going forward. The failure of managers as a group to outperform passive benchmarks does not imply that they lack skill. Furthermore, the lack of persistence does not imply that differential ability across managers is unrewarded, that gathering information about performance is socially wasteful, or that chasing performance is pointless. It merely implies that the provision of capital by investors to the mutual fund industry is competitive.”
Berk and Green continued: “Performance is not persistent in the model precisely because investors chase performance and make full, rational use of information about funds’ histories in doing so. High performance is rationally interpreted by investors as evidence of the manager’s superior ability. New money flows to the fund to the point at which expected excess returns going forward are competitive. This process necessarily implies that investors cannot expect to make positive excess returns, so superior performance cannot be predictable. The response of fund flows to performance is simply evidence that capital flows to investments in which it is most productive.”
However, the failure to identify mutual funds that persistently outperform does not rule out the existence of skilful stock pickers. For example, in their 2020 study Measuring Skill in the Mutual Fund Industry, authors Jonathan Berk and Jules van Binsbergen found that the average mutual fund has added value by extracting about $3 million per year from financial markets, and that the value added is persistent for as long as 10 years. Berk and van Binsbergen concluded: “It is hard to reconcile our findings with anything other than the existence of money management skill.” The problem for investors is that the value added was on a gross, not net, basis. In other words, the beneficiaries of the skill were the fund sponsors. On a net basis, the value added disappeared — investor competition drives net alpha to zero, as the gross alpha is equal to the fee the fund charges its investors.
Valentin Dimitrov and Prem Jain contribute to the literature with their July 2021 study, Yes, Virginia, there are Superstar Money Managers, in which they examined the sample of money manager recommendations from the prestigious annual Barron’s Roundtable over the period 1968-2019. Each year Barron’s invites about ten money managers, and outsiders are not allowed in these meetings. Barron’s refers to the invited money managers as “Wall Street Superstars.” Their sample consisted of 3,472 stock buy recommendations and was free from survivorship bias because it covered the entire 52-year life of Barron’s Roundtable. What might be of particular interest to investors is that the largest number of 628 recommendations were made by legendary investor Peter Lynch during 1986-1995, followed by 551 recommendations by Mario Gabelli during 1980-2019.
Dimitrov and Jain’s findings are consistent with those of Berk and van Binsbergen. First, they found that money managers are skilful — the sample of 3,472 buy recommendations, on average, earned economically meaningful and statistically significant 4.1 percent excess returns over the benchmark S&P 500 Index over the 30 trading days immediately following the meetings. Against the Fama-French five-factor model, the alpha was lower, at 2.8 percent. And beyond the initial 30-day period, there was no reversal in excess returns; hence, the initial reaction could not be attributed to a mechanical reaction to the recommendations. Second, dividing the 52-year-long time series of data into four equal 13-year-long periods, they found that the excess returns in each period were similar — skill had not diminished. Third, Barron’s readers learned of the recommendations only after publication, which could be one to four weeks. Barron’s readers were unable to exploit the skills of the superstar stock pickers, as most of the gains (about 90 percent) came before publication (in the first 15 days) — as Roundtable participants trade on the information prior to publication — and transaction costs basically subsumed the remaining gains. Dimitrov and Jain concluded: “Barron’s readers, on average, do not earn excess returns from investing in the recommendations published in Barron’s Roundtable.”
The takeaway for investors is that, while there is evidence of skilful managers who are able to generate gross alphas for their funds, neither fund investors nor Barron’s subscribers are able to exploit that skill. All of the benefits go to the fund sponsors in the form of high expense ratios and, presumably, the superstar managers themselves, in the form of compensation.
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LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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