Why does active fund performance deteriorate over time?

Posted by TEBI on April 25, 2023

Why does active fund performance deteriorate over time?





It’s well known that active fund performance deteriorates over time. Evidence from both academics and from organisations like Morningstar and S&P Dow Jones Indices, consistently show that the number of funds that beat the market on a cost- and risk-adjusted decreases the the longer the time horizon.

An important question is, why does it become progressively harder for active managers to outperform over time?

One explanation is that outperformance is hard full stop. To keep beating the market again and again is a huge and unrelenting test of a manager’s skill.

Another explanation is that most, or perhaps all, outperformance is not the result of skill at all, but simply random chance. So, beating the market over, say, ten years is like flipping a coin and it landing on heads ten times in a row.

But new research has suggested another reason behind this phenomenon — namely positive skew. Hendrik Bessembinder of Arizona State University, Michael Cooper of the University of Utah and Feng Zhang of Southern Methodist University analysed the returns of more than 7,800 U.S. equity funds between 1991 and 2020. They too concluded that the number of outperformers falls as time goes by.

But they also found that skewness played a significant part. We already know from a previous study that Bessembinder was involved in that the vast bulk of stock market returns are delivered by a very small proportion (about 4%) of stocks. What the researchers found in the latest study is that this positive skewness simply wasn’t observable in monthly returns, but it increased with the length of the horizon, with the effects of compounding.

“These outcomes reflect two important facts,” the authors concluded.

“First, the cross-sectional distribution of long-horizon fund buy-and-hold returns is strongly positively skewed, while such skewness is not observable in the pooled distribution of short-horizon (monthly) returns. Financial planning is often based on assumed mean outcomes… In a positively skewed distribution a potentially large majority of the possible future realisations are less than the mean outcome.

“Second, alpha is a (conditional) arithmetic mean, and arithmetic means are well-known to exceed the geometric means that determine compound returns.”

It’s a fascinating paper which I would encourage you to read. But here is a simplified summary of the findings and what they mean for investors, which I’ve written for clients of rockwealth.



“By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals.”

— Warren Buffett, Berkshire Hathaway shareholder letter 1993


Most people invest for a very long time. The earlier you start the better. You should pay into a pension as soon as you start earning; better still, your parents will have paid into one for you while you were still at school. Most of us invest for all our working lives, but even when we reach retirement, most of us don’t suddenly stop investing in the stock market. Investing really is — or at least should be — a lifelong endeavour.

The problem is, human beings have a present bias. We are so focused on the here-and-now that it can be hard to see the big picture. We’re so finely attuned to what we perceive as short-term threats and opportunities that we lose sight of the fact that what really matters are the returns we receive over many decades of investing.


The industry accentuates present bias

The investing industry and the financial media only make this problem worse by focusing on very short timeframes. Fund performance, for example, is usually broken down into periods of one, three, five or ten years. We often read about how a fund has performed over even shorter periods — six or even three months, for example. But how a fund has performed over only a few months or years is almost irrelevant.

A new study shows just how misleading this emphasis on short-term performance can be. Three finance professors — Hendrik Bessembinder of Arizona State University, Michael Cooper of the University of Utah and Feng Zhang of Southern Methodist University — looked at the returns of more than 7,800 U.S. equity funds over the 30-year period to the end of 2020.




Momentum and high beta: what’s the difference?

What can Woodford investors expect to happen now?

Link carries the can as FCA tries to draw a line under Woodford



TEBI founder Robin Powell and his co-author Jonathan Hollow will be speaking about the murky world of investment fees and charges in London at 5.30pm on Wednesday 17th May 2023.

They’ll be explaining you may be paying for a nice retirement for people you don’t even know, and what you can do start funding YOUR dream life instead.

The event is free, but places are limited, so book early to avoid disappointment:



© The Evidence-Based Investor MMXXIII





How can tebi help you?