Category: ineffectiveness of active fund management

Top 10 Tips for investing in a recession

The Telegraph on 17th July published a list of tips for investing in a recession, which included a contribution by me!

For top investment tips click here

In summary, my view is to be systematic and disciplined … and keep costs down.

Why Active Investing is a Negative Sum Game

In this article well known academics Eugene Fama and Kenneth French reflect on Nobel Laureate William F Sharpe’s 1991 article on the arithmetic of active fund management. This has already been discussed on this blog and you can see a copy of that article here

Cutting through the slightly complex jargon that is used by Fama and French,the essence of what they are saying is that the combined portfolios all active investors have the same weighting in shares as the market as a whole. This means that the combined portfolios can only perform the same as the market, less their costs. It also means that the only way in which an active investor can outperform the market is to do so at the expense of other active investors.

In contrast, passive investors also all hold the same weighting in shares as the market as a whole. This means that their portfolios should perform the same as the market, less their costs. However, as their costs are less than those of active investors, passive investors as a group must outperform active investors.

This article does not seek to deny that some active investors do outperform the market. It is just that their gains have been made at the expense of other equally clever active investors. Other research has shown that winners tend not to repeat and that on the whole, they do not tend to remain winners for very long.

When considering whether to invest actively or passively you have to answer the question ‘Are you feeling lucky?’ For active investors the answer must be ‘Yes’ – in the face of the evidence. For passive investors the answer is ‘No – but at least I will be assured of returns that essentially replicate the market less my costs which are substantially less than for active portfolios’.

From a financial planning point of view, investing should not be seen as a game. Investments are not an end in themselves. Instead they are the means by which individuals fund for the serious financial goals, which they need to achieve in order to lead the future lifestyles that they desire. Speculation on which fund manager is likely to provide better returns than another, in the face of evidence that this is likely to be an unsuccessful strategy, has no place in this process.

Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you

Stock Picking v Index Investing

I have just found this extremely interesting video link which shows Professor Kenneth French talking about Stock Picking and Index Investing. He explains, far better than I ever could, how stock picking is essentially a fools errand … but a very necessary one which enables those of us with more sense to take a cheap ride on the increased market efficiency which their zero sum strategies create. He also makes some very interesting comments about Hedge Funds.

Do Winners Repeat?

A common method of choosing active funds is to look at past performance. This can be done with varying degrees of sophistication. The ratings agencies such as Standard & Poors and Morningstar issue star ratings and these essentially combine past investment performance with an assessment of risk in arriving at the number of stars awarded to a fund.

A recent survey has assessed the effectiveness of using past performance in fund selection by investigating to what extent performance is repeated over a series of 5 year periods from January 1982 until December 2006.

I have summarised the results of the survey of top 30 funds for each five year period below:

Initial 5 year period Still in the top 30 five years later Still Top Quartile

Jan 1982-Dec 1986 0/30 4/30
Jan 1987-Dec 1991 5/30 15/30
Jan 1992-Dec 1996 1/30 12/30
Jan 1997-Dec 2001 2/30 6/30

What it tells you is that the chances of selecting an active fund manager who will still be outperforming his peers even five years later are slim to the say the least. This validates the view that active fund managers in general fail to add value. Whilst there are undoubtedly some that have demonstrated out performance the likelihood that you will choose one is remote.

In summary spending time on selecting active fund managers is a fool’s errand as it is unlikely to add value to the performance of a portfolio. If you are a serious investor your efforts are likely to be better rewarded by investing in the market as a whole and aiming for out performance by allocating some of your investments to under valued and smaller companies. Whilst these expose you to greater risk that investing in the whole of the market there is a reasonable probability that this will be rewarded. See my I help you achieve your lifetime goals for reasons that are important to you
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