Outperforming the financial markets by identifying what securities to buy and sell, and when, is very hard. To quote Mark Hebner in his award-winning book Index Funds: The 12-Step Recovery Program for Active Investors by now in its tenth edition: "Picking stocks or bonds is an ill-fated strategy that wastes time, energy, and money."

Yes, there are bound to be a few winners, but the vast majority of ordinary investors who attempt it will fail. In fact, even professional investors, who devote their working lives to it, and have far more information and much better resources at their disposal than the rest of us, find it almost as difficult.

S&P Dow Jones Indices keeps a regular scorecard on the performance of active fund managers called SPIVA. Morningstar has something similar — the Active/Passive Barometer. What these scorecards tell us, time and again, is that most active managers underperform the market most of the time. Over meaningful time periods, only a small proportion of managers succeed. Nor does this just apply to fund managers in the U.S.; professional stockpickers all over the world have exactly the same problem.

Missed opportunities

We often hear from the fund industry that active managers are about to turn the corner, or that market conditions present a real opportunity for outperformance. But, almost invariably, instead of beating the index, most active managers end up being beaten by it.

Take the first half of 2023, for example. 2022 was a challenging year for equity investors, with the S&P 500 index falling 18.1% over the calendar year. But there was a sharp rebound in 2023, with the index rising 16.9% in the six-month period to the end of June. In theory, this gave active managers a real chance to demonstrate their skill. But 56% of active managers failed to beat their respective benchmarks in the first half of the year.

The long-term picture was much worse. Over a five-year horizon, nearly 62% of active managers underperformed. Over the 15-year period to the end of June 2023, more than 82% of managers across more than 30 different equity categories failed to beat the relevant benchmark. In fact, over the same period, there wasn't a single category in which the majority of active managers outperformed.

"How hard can it be?"

You might be reading this and thinking, "OK, most active managers end up failing, but there's still a small number of funds, in the long run, that do outperform. Surely, with some careful research, it must be possible, perhaps with the help of a financial adviser, to identify those winners ahead of time? How hard can it be?"

Unfortunately, however, your chances of predicting future winners with any consistency are very slim, as a study by Amit Goyal from the University of Lausanne, Sunil Wahal from Arizona State University and M. Deniz Yavuz from Purdue University in Indiana, clearly demonstrates.

Goyal, Wahal and Yavuz studied around 7,000 decisions made by more than 2,000 U.S. pension plan sponsors between 2002 and 2017, involving $1.6 trillion in funds and 775 fund managers. In each case they compared the subsequent performance of the fund managers who were hired to managers investing in the same asset class and region and with a similar investment style.

What they discovered was that post-hiring returns for the chosen fund managers were significantly lower than those for the managers who weren't chosen.

Why funds are chosen

Interestingly, the authors also looked at why certain funds were chosen. In most cases, they found, there were two overriding factors in fund selection: pre-hiring returns, and personal connections between personnel at the plan, or the consultant advising the plan, and the fund management company.

Investors are constantly reminded that past performance does not predict future performance, it's well known that investors continue to act as if it does, and that this irrational behaviour, it seems, also extends to investment professionals.

The researchers found clear evidence of performance chasing. Prior to hiring, the cumulative three-year return of the funds that were hired was 3.34% higher than the opportunity set. But after hiring, the average three-year return difference was −0.85%.

Post-hiring underperformance was particularly marked among equity fund managers, with a difference in three-year cumulative excess returns of −1.13 %. In fixed income, the equivalent difference in returns was only 0.02%.

The researchers then turned their attention to the influence of personal connections on hiring decisions. Using data from Relationship Science, a database that measures professional relationships, they found that fund managers with connections to plan managers or consultants are between 15% and 30% more likely to be hired than managers without connections.

You might be thinking that's no bad thing. After all, consultants could in theory use their connections and personal knowledge to hire money managers they believe will deliver the best returns. But that's not how it works in practice.

To quote the report's authors, "the post-hiring returns of firms with relationships are, at best, indistinguishable from those without relationships, and often significantly worse."

In the three years after they were hired, the connected money managers underperformed their non-hired competitors by an average of 1.12% a year.

Similar studies, similar results

The findings reached by Goyal, Wahal and Yavuz are perfectly consistent with those of other academics who have addressed the question of how hard it is to pick out winning funds in advance.

For example, a 2018 study, updated in 2021, showed how recommendations by investment consultants to hire and fire funds managers tend to extract value from the investment process. Tim Jenkinson and Howard Jones from the University of Oxford, Jose Vicente Martinez of the University of Connecticut and Gordon Cookson from the UK regulator, the Financial Conduct Authority, analyzed the performance of fund managers recommended by investment consultants between 2006 and 2015.

On average, they found, the products recommended by consultants performed no better than other products available to institutional investors. In fact, once fees were factored in, all of the recommended products combined produced returns 0.30% per year lower than a portfolio of all the products available to plan sponsors that weren't recommended.

The researchers also found a possible explanation as to why the funds that were recommended underperformed those that weren't — they were less likely to deviate from the index. Funds that hug the benchmark are less likely to perform disastrously, but are also far less likely to outperform.

When the researchers examined the claims that investment consultants made about their recommendations, they found that they exaggerated their performance by a whopping 2% a year.

The paper concluded that "investment consultants appear, on average, to have no systematic skills in manager selection… (and) tend to overstate their ability to select fund managers."

Luck or skill?

Again, there will always be funds that outperform in the short term, and it's perfectly possible, in theory, to identify those funds ahead of time. But remember: it's very hard to distinguish luck from skill in active fund performance, and, when a fund does outperform, it may well be down to chance alone, or the random rotation of the fund's investment style. You certainly shouldn't be swayed by the notion that an outperforming fund manager is a stockpicking genius.

"Fund managers who are successful in the short term are considered the current financial heroes," writes Mark Hebner, "despite the fact that reputable studies of mutual fund performance over the past 30 years has found there is no reliable way to know if managers with recent winning performance will win in the future."

The logical conclusion for investors is to stop speculating and avoid using actively managed funds altogether.

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ROBIN POWELL is a financial journalist and editor of The Evidence-Based Investor.

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