Don't Try to Pick Up Quarters Off the Street

I was walking on the street this weekend when I noticed a quarter on the ground. My initial thought was to pick it up...but then my knowledge about the stock market immediately kicked in. I suddenly couldn't decipher if I was having a deja vu, dreaming, or actually experiencing this! I thought to myself: If the world of walking the streets of Dallas is anything like the stock market that quarter shouldn't be there. Furthermore, even if it really was there, the action of bending over and picking it up would not overcome the costs (in this case energy and time) of receiving 25 cents. I quickly snapped out of my mental intuition and rightfully picked up the quarter. Oh well...



On the other hand, individual and professional investors believe they are all good at picking up quarters off of the ground or picking the next Microsoft or predicting interest rates or figuring out that international stocks will beat domestic. But they fail to realize two things, 1) those free quarters or opportunities do not consistently exist and 2)the cost of trying to find those quarters will dig you a deeper hole.

When talking to individual investors some feel they are the next stock picker dejour. Again, they fail to realize that there never was and never will be a stock picker dejour - someone who can predict the future and position their portfolio appropriately for the next 20-30 years, beating a portfolio of low-cost, diversified index funds.

One of the biggest mistakes an investor can make is believing that they have the "skill" or "knowledge" to outperform the market (perform better). Usually this conviction arises by looking in the rear view mirror while driving forward. Investors plow into funds after strong performance and depart after weak performance. Just because a fund has had great performance in the past does not mean it will continue to do so. Furthermore, once you invest in a fund you do not instantly achieve the past returns of the fund. If investing worked that way everyone would be rich.

An active manager attempts to outperform the market (index) by assembling a portfolio that is different than the market. They construct their portfolios through innumerable methods: account records, earnings, the CEO, rating services, the alignment of the stars, literally anything their brain can trick them into believing that a pattern or rationale exists for.

I have asked dozens of investors why they believe they have more information than millions of other market participants. I ask why they think they can outperform the market even though the odds (2 out of 10 each year) are against them. I ask why they think quarters are free. I have never gotten a response to this question.

The Failure of Active Management

Over the years we have encountered many people who question our thoughts on the "failure of active management". Some reply with, "Well, how come Wall St. exists?" or "So, you are telling me Wall St. has it all wrong?". In which we reply with a resounding "Yes!". At Arianna Capital we hold the believe that stock picking and timing the markets does not bode well for most investors. Rather, suggesting that the average investor would fare better with a simple index fund, taking advantage of market returns preventing one from making emotional mistakes such as stock picking and timing the market.

Thankfully, there exists an institution to keep "score" on how these active funds perform relative to a simple index. "The S&P Indices Versus Active Funds (SPIVA) Scorecard reports performance comparisons corrected for survivorship bias, shows equal- and asset-weighted peer averages, and provides measures of style consistency for actively managed U.S. equity, international equity, and fixed income mutual funds." An apples-to-apples comparison of active vs passive management. Let's check out the results:

Over the last five years, the S&P 500 has outperformed 60.8% of actively managed large-cap U.S. equity funds; the S&P MidCap 400 has outperformed 77.2% of mid-cap funds; and the S&P SmallCap 600 has outperformed 66.6% of small-cap funds.

The five-year data results are similar for actively managed fixed income funds. Across all categories, with the exception of emerging market debt, more than 70% of active managers have failed to beat benchmarks.

On average, academics tell us that roughly 75% of actively managed funds will under-perform relative to their benchmark. Looks as if the the SPIVA scorecard bolsters this statistic. If the professional money managers who spend night and day trying to outsmart the millions of market participants cannot seem to consistently accomplish their goal, which is to provide value ontop of the benchmark, what makes you think you can or your broker/advisor at Morgan Stanley, Merrill Lynch, UBS, or Citi/SmithBarney can? If that's not enough to convince you:

The turmoil of the past five years saw 29% of domestic equity funds, 21% of international equity funds, and 10% of fixed income funds merge or liquidate.

This statistic tells us that funds managed by professionals either liquidated or merged due to poor results. Why else would they merge or liquidate? To conceal the failure of active management.

Don't fall into Wall Street's gimmicks, just look at the numbers. Next time you talk to a salesman at Edward Jones, Merrill Lynch, or Raymond James show him/her the SPIVA scorecard and ask him how he/she can provide value. He/she will probably tell you that they can help you stay away from these under-performing funds or identify the "better" ones. Ask them how. If they have an answer, you know they are a charlatan or mountebank.