You are the shills of unscrupulous indexers

75% of portfolio managers underperform. I am told this by everyone. I am strongly inclined to believe it, simply because everyone else does. Even clever people tell me people like me cannot outperform consistently. Except I have, for 9 years with the exception of 2000, outperformed the market, or a benchmark of stocks based on a sector or grouping of sectors, generally based around telecoms and technology.

Today I discovered that of all the funds I know to be actively managed by employees of my beloved Swiss gnome overlords (admittedly not a scientific sample, neither the funds nor the gnomes), all are currently ahead of their benchmarks. The Euro small-mid cap guys I sit with told me that largely all their peers are ahead of their benchmarks for the year. While this evidence is only anecdotal, it still does not compute, and I can think of a number of interesting explanations: I am acquainted with the cream of global investors, all the bad funds have disappeared in a remarkable example of survivors’ bias, or the 75% rule doesn’t actually work all of time. There may be other reasons.

Then there’s this, from that interesting Odd Numbers blog on Norwegian individual investors who beat the market consistently over a period of time tend to continue beating it.  As the unshaven Odd Numbers blogger Zubin Jelveh points out, 

In fact, the oft-cited statistic that 75 percent of mutual fund managers can’t beat a market index may apply here too. The researchers say a substantial proportion of individual investors can outperform the market, but unfortunately they don’t say what that proportion is. (I’ve gotten in touch with the researchers about this, and will update as soon as I find out more.)

I too would be interested. It may be that only 25% of managers outperform, but it my also be that this 25% do so reasonably consistently. This is a much more interesting statistic than that 75% of them underperform. Making sure one’s money resides with these guys would be the right thing to do, and much much better than holding silly index funds. To be sure there are duff managers, I have met many. Caveat emptor, blah blah. But it sounds like consistent past performance over a long time may indeed be a guide to future returns.

It might also be that the 75% statistic is simply wrong, and here’s the thing: I haven’t ever found the source data. Has anyone? I googled my brains out trying to find it. I probably won’t send a copy of Spinoza’s Ethics in the original latin to whoever sends me the link, but I might, so you may as well try.

Might someone just have made it up?


8 thoughts on “You are the shills of unscrupulous indexers”

  1. I think you get close to 75% by sheer intuition. The market as a whole, obvs, can’t outperform the market. And the one thing we know from looking at hedge funds and private-equity shops and Warren Buffett is that there is a certain set of large, consistent outperformers. Which means that the market ex those large, consistent outperformers significantly underperforms the market. So let’s snip off the top 1% of fund managers, and draw a bell curve through the rest, with the middle of it some significant underperformance. At that point you’ve got probably over 65% of fund managers underperforming the market BEFORE fees. Add in fees, and it’s trivial to get to 75%.

  2. We don’t do Bell Curves here Felix. That disqualifies your analysis from the start. Ultimi Barbarorum is hosted and written in Extremistan. I don’t like snipping off the top 1% of anything to do with statistics, either.

    But suppose I was to ignore that part of your comment, while I have to agree with you that the market is not able to outperform itself, it is certainly theoretically possible for all portfolio managers as a class to outperform an index, assuming that the total set of market participants are not all portfolio managers. Look at the exampe of small-mid cap European PMs I mention above. Simple observation backs this up: the market is also made up of large corporate holders, lazy individuals, insane quants, index funds, central banks, PE houses, broker inventory, VC guys waiting to exit, treasury holdings and incompetent hedge fund managers. All these have vastly different time horizons and investment goals from what we are calling PMs in this discussion, many are not even aware they are underperforming a benchmark in one year or another and many do not care if they do. They don’t mind holding the crap stocks.

    In some market periods, such as the tech markets of 1999 to March 2000, even lobotomised PMs can outperform (and there is evidence that if you damage the emotional parts of your brain it actually helps). I do not know of anyone who did not outperform in that era. Again, that’s just anecdotal.

    One of my major objections to the 75% “law” is that it is just irrelevant; flip it around. Again, if 25% of PMs consistently outperform net of fees, THAT is the astonishing statistic. It destroys the efficient market myth upon which most financial theory is based, it provides more than enough investment capacity for the most basically informed punter to find someone decent to manage his nest-egg. These 25% clearly have something that they do which works, and it would seem prima facie possible, with enough study, to find out what that thing, or things, is, and then we shall all be rich.

  3. Your “flip” is superficially clever, Mr Spinoza, but I’m afraid that if you tried it in real life you’d end up on your famously-large nose. The 75% “law” says nothing, flipped or unflipped, about consistent outperformance. Obviously, the shorter your timescale, the easier it is to find “consistent” outperformers. If you bring the timescale down to one year between 1999 and 2000, then I daresay it’s incredibly easy to find people who “consistently” beat the market for that short period. As you lengthen the timescale, it becomes increasingly difficult. But, to pick an example of a man I once interviewed, Albert(o) Vilar did genuinely consistently outperform from about 1974 to the top of the bubble in 2000. But even he was not, it turns out, a consistent outperformer.

    In general, it’s easy to outperform if you’re long risk in a bull market. Vilar was long the riskiest bits of tech in a period when tech went from nothing to bubble.

    And of course then there’s the question of benchmarks. My underperforming index fund can still outperform your outperforming small-cap fund if small caps go down and the broader market goes up. As a result, absent some improbable portable-alpha strategy, hiring an outperforming PM is secondary to getting your asset allocations right.

    And this is where things get profound, Mr Spinoza. It might be possible for a super-smart telecoms analyst to find himself better at picking telecoms than the market as a whole. But to beat the market as a whole, it’s not enough to be smart at telecoms. You have to be smart at asset allocation too, and you need to be able to find the clever PMs in every asset in which you want to invest. NOW do you see why paying buy-side professionals to invest your money is not so likely to pay off, in aggregate? There are so many places where things can go wrong: a bad sector bet here, a bad PM choice there. Added to the fact that things here in Extremistan have a habit of blowing up quite spectacularly — rather more often, indeed, than you’ll find truly astonishing performance on the upside.

  4. Why try to beat the market as a whole all the time? Why not find yourself a super-smart techie guy who knows his sector inside out, can go long and short, and has enough of a diversified universe to remove single stock risk? Then find yourself a banking guy, then an oils guy, etc etc, pay them 2 and 20, and make solid, 10-15%, reliable absolute returns. For sure, a sector based long only fund will underperform both cash and a wider index when that sector no work. A general fund without a simplifying system, discipline or process may be too complicated to work reliably (although there are professionals who can do it).

    I take your point about the 25% of outperformers (assuming the law holds) not necessarily being the same ones in each period. But again, you don’t know that that is NOT the case, either; we are both speculating in the absence of the data. I imagine that a large proportion of that 25% in any period you see again in the next; at least that is what your hairy colleague Zubin blogs about the Norwegians.

    I do not see that paying people to manage money actively is foolish, or unlikely to pay off. The fact that a lot of people do it, and the industry exists, and has done for centuries, makes it unlikely to be total bollocks.

  5. Hey Baruch,
    Very interesting post. I dug around a bit to try to find the first reference to the 75 percent figure. I couldn’t find anything in NYT or WSJ (though WSJ had a late 80’s study on bond index fund performance that said 80% of those funds outperformed actively managed bond funds.)

    I did find this, however, an index fund proponent in 1995 stating the 75 percent figure.

    I also think you’d be very interested in this 2006 study: “We find that a sizable minority of managers really do pick stocks well enough to more than cover their costs. Moreover, our bootstrap indicates that the superior alphas of these managers persist.”

  6. Zubin! You make me very happy! Felix will be gnashing his teeth, however, as I seem to be completely vindicated.

    The links are very interesting; the guy in the first one got a bit shirty at one point, equating active managers with communists. Never heard that one before. The indexistas were clearly a bit desperate in 1995.

    What on earth is a “bootstrap analysis”? I hope it is not dodgy.

    It seems the 75% rule will remain unattributable. My wife (who did a CFA) assured me she has seen academic articles which derive the figure, or ones like it, but when I pressed her she also couldn’t remember names or dates. It is clearly some urban myth, so infused into our consciousness by simple repetition, passed on by word of mouth, that it has the Status of Truth. I hope they paid Vanguard marketing guy who came up with it a LOT of money.

  7. Wow, I read the link and am still not sure what “Bootstrapping” is. But it sounds like “making data up in the absence of evidence to fit my own preconceived notions of the outcome of whatever it is I am investigating.”

    Thanks for that Nuntius; in fact, it sounds like bootstrapping is 90% of what I do everyday. The rest is making tea and eating lunch. Hone your bootstrapping skills and I am sure you will be an excellent portfolio manager.

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