Waypoint's Evidence-Based Investment Insights: Financial Gurus and Other Fantastic Creatures

Welcome to the next installment in our series of Waypoint's Evidence-Based Investment Insights: Financial Gurus and Other Fantastic Creatures.

 In our last piece, “Ignoring the Siren Song of Daily Market Pricing,” we explored how price-setting occurs in capital markets, and why investors should avoid reacting to breaking news. The cost and competitive hurdles are just too tall. Now, let’s 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 the price paid to active “experts”:

 “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 we covered in “You, the Market, and the Prices You Pay,” independently thinking groups (like capital markets) are usually 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 breaking 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 forecast future prices. They must still try to successfully predict the unpredictable. Just like anyone else, they cannot foresee the news itself, let alone the reactions to unexpected news that is not yet known. Particularly after the costs involved in trying, outmaneuvering prices set by group intelligence usually remains a prohibitively tall hurdle.

 The Proof Is in the Pudding

But maybe you know of an extraordinary stock broker, fund manager, or media guru who strikes you as being among the elite few who are up to the challenge. Maybe they have a stellar track record, impeccable credentials, a secret sauce, or brand-name recognition. Can you rely on their latest forecasts?

 Let’s set aside market theory for a moment and consider what has actually been working. Bottom line, if investors could depend on expert stock-picking or market-timing forecasters, we should expect to see credible evidence of it, with more “winners” than random chance would explain.

 Not only is such data lacking, the body of evidence to the contrary is overwhelming. Each season’s crop of star performers often fails to survive, let alone persistently beat comparable market returns moving forward.

 Plus, the best way to profit from a guru’s stellar track record requires you to jump on their band wagon while they’re still on a hot roll, so you too can profit from their future success. In the absence of a time-travel machine, this is once again a daunting challenge.

 To cite one of many sources, Morningstar publishes a semiannual “Active vs Passive Investment Management Barometer Report,” comparing actively managed funds to their passively managed peers. In its Midyear 2023 report, there was some relatively good news for active investors. For the 12 months from June 2022–June 2023, Morningstar found, “Fifty-seven percent of active strategies survived and beat their average passive counterpart … well above their 43% success rate in calendar-year 2022.”

 Of course, if 57% of active strategies survived and beat the market for the 12 months ending June 2023, this means a relatively hefty 43% of them did not.

 Thus, even the brief pop was not a resounding success. Nor do we expect it to be long-lived. As Morningstar also reported:

 “Actively managed funds’ recent surge did little to change their long-term track record against their passive peers. Just one out of every four active strategies survived and beat their average passive counterpart over the 10 years through June 2023.”

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 Journal of Finance 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 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” on fund performance. 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.”

·         Yet another study, “Mutual fund performance at long horizons,” appeared in the January 2023 Journal of Financial Economics. Its authors concluded that fund managers still struggled to outperform the market (as proxied by the S&P 500). They estimated “an aggregate wealth loss to mutual fund investors of $1.02 trillion,” based on long-horizon mutual fund underperformance. In separate commentary, the authors wrote, “This wealth loss reflects the combined effect of mutual fund fees and investors’ timing decisions.”

Your Take-Home

So far in our Evidence-Based Investment Insights series, we’ve been assessing common investment challenges. Fortunately, there’s a way to invest that lets you nimbly sidestep rather than face these stumbling blocks: You can simply let the market do what it does best on your behalf. Next up, we’ll introduce the strategies involved, starting with what some have described as investment’s only free lunch: diversification.