We see news reports surfacing that active fund managers are having a bad year, underperforming their broad benchmarks. The first excuse -earlier this year- was that there was simply no volatility. Less room to show their value. Then -more recently- the excuse morphed to now there was volatility, and who could have expected that?
Industry experts are quick to advise -with uncanny wisdom- that we should dismiss such underperformance reports. After all, these reports they suggest only focus on the short-term, average fund manager. It's the star managers they suggest who outperform, over the long-run, and are most likely to continue their magic in the future. Is that all there really is to it? Hunting down a historically successful fund manager, and that must explain most of what one needs to know?
Let's evaluate such comments. Look at this performance illustration two paragraphs down. It shows a group of all fund managers on a recent S&P Dow Jones screen that tabulates the subsequent 5-year performance of fund managers, grouped by their historic 5-year performance. Clearly multiple 5-year periods would be a long enough period to capture a large swath of managers, and measure their degree of performance persistence. We show both the historic top quartile outperformers (blue color) and historic second quartile outperformers (orange color).
For example, the chart on the upper left shows that among those fund managers who were top quartile performers in the past 5-years, and also continued to manage their fund another 5-years, 55% continued to outperform (comprising of 33% remaining in the top quartile plus we see 22% slipping in rank but were anyway in the second best quartile). And on this same chart we also see that among those fund managers who were in the second best quartile in the past 5-years, slightly more (or 56%) continued to outperform.
But wait, we show four different charts in the illustration above. Obviously only one is correct. But shouldn't that be easy to identify? After all, those "experts" have told us that outperformance persists and hence selecting the correct results should be easy. On this original article, readers were encourages to try your own hand at being a high performing fund manager, and take your own shot at this analysis. If you haven't already, please do so now.
Also know this chart is just showing manager's performance against their average peers, and doesn't account for what we described on the link above as the tendency for the entire group to typically underperform (and always be inventing logic as to why). The voting mechanism is now turned off, and the results below show how the first 300 readers voted for what the correct chart should be. Thanks much for participating!
First we identify the correct chart in the illustration of four results, and then go through the explanations. The correct answer is the lower left chart and it was selected only 29% of the time (88/300). Clearly not great, but more middling than one might assume from the self-selected voters. And incorrect votes instead were mostly selected, at 71% of the time. Of these 212 incorrect votes, 38% of them (80/212) -concerning the upper left chart- actually works against to the logic of outperformance persistence. Finally 64% of the wrong votes total only 134, and were nearly equally split between the two random charts on the right.
Let's now start with the chart on the lower right, and mention that it is just a random distribution. Very easy to have thought this could be a plausible scenario. And what are the upper row of charts? Those are simply the horizontal-mirror image of the lower row of charts (e.g., Q4 values on the bottom row are the Q1 values on the top row).
Of course it would have been too easy to have selected the upper left chart. Anyone would have been able to do it, and the industry would not have any distribution remaining for anything other than the top performers. However this is the ill-logic that the industry experts state is the main justification for active management: top performers they state remain top performers instead of collapsing to mediocrity (shown in the correct lower left chart) just as all other investors jump in too late.
Bear these results in mind as well, when one tries to falsely convince you that a "should have been" hypothesis is "reality". Their incentives are not aligned with yours, and in fact, the the actual results are even worse than an otherwise similar-looking "random noise"! Sometimes we even get communications back from those in industry after these sorts of blog articles, but never are these individuals able to prove their case. Therefore when possible, embrace the power of passive investing in the broad benchmark index.
For your own records, here is the S&P Dow Jones study used. Also please make sure to sign up for this blog e-mail subscription using the RSS tool on the right of the blog page, or this form.
Industry experts are quick to advise -with uncanny wisdom- that we should dismiss such underperformance reports. After all, these reports they suggest only focus on the short-term, average fund manager. It's the star managers they suggest who outperform, over the long-run, and are most likely to continue their magic in the future. Is that all there really is to it? Hunting down a historically successful fund manager, and that must explain most of what one needs to know?
Let's evaluate such comments. Look at this performance illustration two paragraphs down. It shows a group of all fund managers on a recent S&P Dow Jones screen that tabulates the subsequent 5-year performance of fund managers, grouped by their historic 5-year performance. Clearly multiple 5-year periods would be a long enough period to capture a large swath of managers, and measure their degree of performance persistence. We show both the historic top quartile outperformers (blue color) and historic second quartile outperformers (orange color).
For example, the chart on the upper left shows that among those fund managers who were top quartile performers in the past 5-years, and also continued to manage their fund another 5-years, 55% continued to outperform (comprising of 33% remaining in the top quartile plus we see 22% slipping in rank but were anyway in the second best quartile). And on this same chart we also see that among those fund managers who were in the second best quartile in the past 5-years, slightly more (or 56%) continued to outperform.
Also know this chart is just showing manager's performance against their average peers, and doesn't account for what we described on the link above as the tendency for the entire group to typically underperform (and always be inventing logic as to why). The voting mechanism is now turned off, and the results below show how the first 300 readers voted for what the correct chart should be. Thanks much for participating!
upper left (80), upper right (64)
lower left (88), lower right (68)
First we identify the correct chart in the illustration of four results, and then go through the explanations. The correct answer is the lower left chart and it was selected only 29% of the time (88/300). Clearly not great, but more middling than one might assume from the self-selected voters. And incorrect votes instead were mostly selected, at 71% of the time. Of these 212 incorrect votes, 38% of them (80/212) -concerning the upper left chart- actually works against to the logic of outperformance persistence. Finally 64% of the wrong votes total only 134, and were nearly equally split between the two random charts on the right.
Let's now start with the chart on the lower right, and mention that it is just a random distribution. Very easy to have thought this could be a plausible scenario. And what are the upper row of charts? Those are simply the horizontal-mirror image of the lower row of charts (e.g., Q4 values on the bottom row are the Q1 values on the top row).
Of course it would have been too easy to have selected the upper left chart. Anyone would have been able to do it, and the industry would not have any distribution remaining for anything other than the top performers. However this is the ill-logic that the industry experts state is the main justification for active management: top performers they state remain top performers instead of collapsing to mediocrity (shown in the correct lower left chart) just as all other investors jump in too late.
Bear these results in mind as well, when one tries to falsely convince you that a "should have been" hypothesis is "reality". Their incentives are not aligned with yours, and in fact, the the actual results are even worse than an otherwise similar-looking "random noise"! Sometimes we even get communications back from those in industry after these sorts of blog articles, but never are these individuals able to prove their case. Therefore when possible, embrace the power of passive investing in the broad benchmark index.
For your own records, here is the S&P Dow Jones study used. Also please make sure to sign up for this blog e-mail subscription using the RSS tool on the right of the blog page, or this form.
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