Most sports fans can think of a coach who succeeded with one team but then flopped with another. George Seifert and Mike Shanahan are good examples from the NFL, as are George Karl and Mike D'Antoni from the NBA.

Managing an active investment fund is not dissimilar to managing a sports team. No matter how well-known you are, the fact that you've succeeded in the past is no guarantee you'll do so in future.

In his book Index Funds: The 12-Step Recovery Program for Active Investors, Mark Hebner uses the analogy of movie sequels.

"Men in Black II, Ocean's Twelve and The Hangover, Part II," he writes. "All of these movies have one thing in common: they were abysmal sequels to blockbuster movies. We long to regenerate scenarios when everything comes together perfectly and the stars align, but that kind of success is rarely duplicated.

"As hard as it is to (do) in the film world, it is even more difficult for these all-star money managers to duplicate their past success."

Luck Versus Skill

Note that Hebner doesn't say that repeating past success in fund management is as hard as it is in Hollywood; his point is that it's more difficult. So why does he say that? The simple answer is that it's much easier to identify genuine ability in, say, a sports coach, movie director or film star than it is as an active fund manager.

Few people could argue that Martin Scorsese, say, or Tom Hanks are good at what they do. They've worked on too many successful movies and won too many awards for that. Fund management, on the other hand, is littered with examples of people who just got lucky and got one or two big calls right, and attracted much publicity as a result, but then performed dismally.

In his best-selling book, A Random Walk Down Wall Street, Yale professor Burton Malkiel wrote: "I have become increasingly convinced that the past records of mutual fund managers are essentially worthless in predicting future success. The few examples of consistently superior performance occur no more frequently than can be expected by chance."

Outperformance is Fleeting

Anyone who has studied active fund performance in any detail will tell you that outperformance rarely lasts for long. S&P Dow Jones Indices regularly publish what it calls persistence scorecards, which consistently show that outperformance by actively managed funds is fleeting. For example, the U.S. Persistence Scorecard Year-End 2023 shows that as of December 2019, among top-quartile funds within all reported active domestic equity categories, not a single fund remained in the top quartile over the next four years.

Think about it. If a fund manager had genuine skill, you would expect them to repeat that skill on a consistent basis. But the data show us, time and again, that it very rarely happens. In fact, if a manager has performed exceptionally well in the recent past, they often soon revert to the mean. And yet funds with strong performance over, say, one, two or three years, are just the funds that unsophisticated investors tend to invest in.

That's what David Swensen, Yale's celebrated former Chief Investment Officer, was referring to when he wrote in his book, Pioneering Portfolio Management: "Most investors follow the crowd down the path to comfortable mediocrity."

Indexing Makes Much More Sense

So what does all this mean for investors? The most important lesson is, don't be swayed by a fund's past performance; an impressive recent track record very rarely translates into long-term outperformance in the future.

How, then, can you identify, in advance, an active fund that will outperform consistently going forward? The simple answer is you can't — not least because there so few of them.

In fact, research by Morningstar has shown that there is only one thing that gives you any indication at all as to how a fund will perform in the future and that's how much it costs. In other words, the lower the annual management fee and ongoing trading expenses are, the better its net performance is likely to be.

It's true, some actively managed funds are cheaper than others, but index funds are almost invariably cheaper still, and, compounded over decades of investing, those lower costs will make a big difference.

"You will almost never find a fund manager who can repeatedly beat the market," Jack Bogle wrote in The Little Book on Common Sense Investing. "It is better to invest in an indexed fund that promises a market return but with significantly lowered fees."

Why Are Active Funds Still So Popular?

You may be wondering why so many people still invest in actively managed funds in the face of overwhelming evidence that active managers struggle to add value through stock selection or market timing once fees and charges are factored in.

Well, one reason is that many people still aren't aware of the evidence. Another is that they're overconfident. In other words, although they know, intellectually, that the odds are stacked against them, they still think that they will be among that small fraction of active investors who will beat the market in the long run.

But perhaps the biggest reason is that most of the professionals investors look to for guidance have their own reasons for recommending active funds — whether that's fund managers themselves, brokers, advisors, investment consultants or even investment journalists. Often their salaries depend on perpetuating the myth that active funds are best. Active investing, to put it bluntly, is far more lucrative for the investing industry than passive investing is.

As Mark Hanna explained to an impressionable Jordan Belfort in The Wolf of Wall Street: "The name of the game (is) moving the money from the client's pocket to your pocket." Of course, most financial professionals, thankfully, have higher ethical standards than either of those characters, but, whatever your line of work, it's very hard not to be influenced at all by financial self-interest.

What a great movie The Wolf of Wall Street was, by the way. Let's just hope they never make a sequel.

 

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ROBIN POWELL is IFA's Creative Director. He always works as a freelance journalist and author, and as Editor of The Evidence-Based Investor.

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