The Long Odds of Beating the Market

Mutual Fund Performance, 1970 to June 20141

# of Funds % of Funds
Mutual fund universe in 1970 358 100.0%
Number of funds that survived the entire period 107 29.9%
# of funds that outperformed benchmark 45 12.6%
# of funds that outperformed benchmark by 2%+ 3 0.84%

The reality that beating the market is really hard is one that I think is starting to set in for a lot of investors. Simply put, the odds of beating the market are so low that it was almost a foregone conclusion that investors would start shifting away from actively managed strategies.

One sign of this is the data that tracks mutual fund inflows and outflows. While traditional active management shops like American Funds are shedding assets like they’re going out of style, index and passively managed fund families are growing at record pace.

I also see this phenomenon on a more anecdotal and personal level in conversations that I have with investors of all ages. It’s much less common these days for someone that I talk to not to have at least heard of index funds, for example, and at a minimum be curious about them.

The Insatiable Desire to Beat the Market

However, even in light of all of the evidence that attempting to beat the market is not a very sound strategy, I think most investors still believe it’s possible if you know what you’re doing.

More importantly, in their minds, they see beating the market as the ticket to success. In other words, their view might be best summed up as, “yeah, the odds of beating the market are low, but the rewards of doing so are too spectacular not to try.”

They might go on to reference Warren Buffett and Berkshire Hathaway before ultimately convincing themselves that beating the market can be done simply because their are living examples of such success.

Given this mindset as a starting point, I thought it would be interesting to consider the highly unlikely sequence of events that are required in order to actually beat the market. Using history as a guide and the track records of highly qualified and educated mutual fund managers, this is what would need to happen in order to achieve market-beating success:

  1. Select an actively-managed fund that performs well enough to avoid being liquidated or merged with another fund during your investment horizon.
  2. Remain invested in the fund through the inevitable storms when the manager underperforms for long periods of time (almost certainly causing you to second-guess your strategy).
  3. Benefit from gross alpha (excess returns before fund expenses) that is high enough to fully offset the fees of the fund and still pass along outperformance to you, the investor.

Let’s take a walk through each of these in a bit more detail to see just how unlikely it is for an investor to enter the active management gauntlet and come out successful on the other side.

How Long do Mutual Funds Live?

The short answer: Not very long.

If you started investing in 1970, you had 358 U.S. stock mutual funds to choose from2. Certainly a large pool, but nothing compared to the thousands of mutual funds and ETFs in the marketplace today.

Of those 358, only a shade over 100 existed as of June 2014. The rest were either closed/liquidated or merged with another fund. Simply put, that means you had a 3 in 10 chance of choosing a fund that merely managed to stay alive for 44 years. Pretty poor odds for what in reality isn’t that high of a bar for success.

It might seem surprising that so few funds were able to survive, but it really isn’t. The vast majority of actively managed mutual funds die premature deaths.

While we can’t say that the cause of death for every fund is bad performance, in most cases that is certainly the reason. Mutual fund companies don’t close winning funds very often because touting the performance of those funds is what keeps the active management asset gathering game alive.

Even the Winners Look Like Losers for Much of Their Life

Assuming we get past the first challenge by successfully choosing one of the roughly 100 funds that managed to avoid the axe, the second challenge might be even harder: Staying invested when things look really bleak.

A big misconception about winning managers is that they always outperform. In other words, investors mistakenly assume that the smartest managers not only beat the market, but they are consistent in doing so.

The folks at Research Affiliates looked into this and found that not only is outperformance rare, it is far from a steady ride along the way if you are lucky enough to experience it.

They measured this by tabulating the number of quarters during a fund’s lifetime in which it had underperformed its benchmark over the prior three-year period. Each quarter for which this was true, the fund was determined to be on the “watch list.” Presumably, an investor would be highly concerned by seeing three consecutive years of poor performance.

If you look at the same group of 358 funds that we started with, you would assume that the ourperforming funds would rarely if ever experience three straight years (12 consecutive quarters) if underperformance. That assumption would be very wrong.

In fact, the winning funds spent between 36% to 48% of their lives on the watch list!4 Think about that for a second. Even the very best funds looked absolutely pitiful for roughly 4 out of every 10 quarters. That’s 15 to 20 years out of the 44 year period where bailing out probably seemed like the right answer.

You’d need an unbelievable amount of faith in the manager and the strategy to stay invested with performance like that!

Overcoming Incredibly Long Odds for Insultingly Meager Rewards

So let’s assume that we were able to clear both the first and second hurdles. The next question is: What did we get for overcoming the long odds of beating the market?

Well, of the roughly 100 funds that stayed alive throughout the period, less than half (45) also managed to outperform their benchmark. That slices are odds of success down to a pretty grim 12.6%. Not good.

Unfortunately, that’s not the end of the bad news. Logically speaking, if we are going to bear the burden of a high risk that we will underperform, the rewards better be sweet enough to make it worth our while, right?

Unfortunately, that’s not the case when you endeavor to beat the market. Of that small group of 45 funds, just 3 managed to deliver returns of 2% or more in excess of their benchmark. Three funds!

To bring it full circle that means that of the 358 funds we started with, less than 1% (0.84% to be exact) delivered the kind of market-beating results that actually move the needle. The other 355 funds either performed so poorly that they were quietly taken to the woodshed or they roughly approximated their benchmark with almost certainly more risk.

If those odds don’t convince you to embrace passive investing, I’m not sure what will!

Sources:
1. Hiring Good Managers is Hard? Ha! Try Keeping Them!, Fundamentals by Research Affiliates, November 2014
2. Ibid.
3. Ibid.
4. Flying High: RAFI at 10 Years, Fundamentals by Research Affiliates, March 2015

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