A friend recently sent me an email asking for my advice regarding a one of his mutual fund holdings.

The fund underperformed the market pretty seriously over the last year. As a result, it now has 3-year and 5-year performance records that are below those of either an S&P 500 index fund or a Wilshire 5000 index fund–despite the fact that the fund was a big outperformer in prior years.

His question was how to know whether the fund manager had “lost his touch.”

My answer, of course, was that there’s no way to know. And in fact, it’s impossible to say for sure whether the fund manager ever had a “touch” to begin with.

His question highlights what I see as one of the biggest issues with holding actively managed funds:

• If the fund has outperformed the market over the period that you’ve owned it, how do you know whether the fund manager has genuine skill or just good luck?
• If the fund has underperformed, is it because the fund manager “lost his touch?”* Or is he still a skillful manager–one who has simply had a bad year? Or, was the fund manager never skillful to begin with?

In either case, you’re stuck asking yourself, “should I continue holding this fund?”

Index Funds & Peace of Mind

By way of comparison, with an index fund, you never have to rely on the existence of a brilliant fund manager. All you’re betting on is the likelihood that the businesses of the world, over time, earn a net profit.

(Side note: That’s just one of the reasons why I sleep better at night knowing that I’m invested in index funds.)

What about you?

For those of you who invest in actively-managed funds, how do you decide when to throw in the towel and find a new fund?

*In terms of the possibility of a fund manager “losing his touch,” I doubt that any truly skilled professional would spontaneously lose his skill. However, if his above-average performance was the result of exploiting a particular market inefficiency, it’s possible that that inefficiency could eventually be eliminated, causing the fund’s above-average performance to end.

Write one.

Then sell subscriptions.

Ta-da!

Troubleshooting (in case you need a little more help)

What’s that? You don’t have a history of successful stock picking? No problem: Just come up with any stock-selection strategy and back-test it to see if it’s worked over the past [period of your choosing].

It didn’t work? Again, no problem: Just continue back-testing assorted strategies until you find one with an absurdly high performance record. Once you do, heavily promote that past performance, while only mentioning in a small footnote that you didn’t actually own any of the investments mentioned over the period in question. Apparently, nobody will notice.

Won’t people figure out that it’s a scam once they see that your strategy isn’t working going forward? Yes, they will. But don’t worry; it will probably take a few years. In the meantime, just start a new newsletter with a new back-tested-for-success strategy.

Or–if you don’t like my method–Carl from Behavior Gap has an alternative (and perhaps better) way to manufacture an excellent past performance record.

Now get out there and go make your fortunes!

Get Rich Slowly (the single largest personal finance blog, I believe) recently began hosting a regular column from a Motley Fool writer.*

Score one for the bad guys.

But everybody loves the guys from The Motley Fool, right?

Spare me.

A few headlines to be found on Fool.com as I write this (5/7/09):

• “5 Cold Stocks Heating Up”
• “5 Stocks with a Bright Future”
• “These Are the Market’s 10 Best Stocks”

Ugh. If those headlines aren’t a perfect example of a “get rich quick” philosophy, I don’t know what is.

They promote their newsletters’ performance with large green lettering: “Outperform by 40.05%.” To me, that sounds suspiciously like they’re indicating that you will outperform by that amount if you buy their newsletter. Am I the only one to whom this looks like a misleading use of past performance figures?

What The Fools do:

As far as I can tell, The Motley Fool’s entire business is built upon convincing people that it’s easy to beat the market.

Never mind the fact that only a handful of investors have ever done it for a sufficiently-extended period to give us any sort of confidence that it was due to anything other than luck.

Never mind the fact that every single trade is a negative-sum game due to transaction costs.

Never mind the fact that, in total, investors’ quest to beat the market is impossible by definition.

Never mind the fact that if we stopped paying newsletter publishers, stock selection services, active fund managers, and all the other charlatans who encourage us to engage in this fruitless endeavor, we’d be better off by $100 billion every year.

My complaint

My issue is not with the particular stock picks that they promote. My complaint is with their promotion of the idea that stock picking is a prudent form of investment.

To think that individual investors (Yes, that means you.) have any meaningful advantage over the institutional investors–i.e., the people with whom we’re trading when we buy or sell stocks–is nonsense.

If we could remove our emotions for a minute, it should be obvious that it’s rare for individual investors to know anything that the institutional investors don’t. We have less time to monitor our investments. Less access to research. Less analytical resources to use.

Both common sense and an enormous body of research tell us that our best bet is simply to stop trying and invest instead in low-cost, passively managed funds. If anybody tells you that it’s easy to beat the market by picking stocks, they’re probably either

1. poorly informed, or
2. about to sell you something.

Spend a couple minutes on the Fools’ website, and I think we can see which group they fall into.

The fools on index funds

Yes, I’m aware that they also promote index funds. But they do it in the most half-hearted, two-faced way possible. For every article on their site promoting index funds, there’s another article right next to it indicating that any investor with an ounce of intelligence can beat the market.

What do you think?

Am I wrong? Is it reasonable to listen to The Motley Fool? Or am I right that trying to beat the market is a fool’s errand?

Please let me know what you think in the comments.

*To be clear, Robert Brokamp’s articles appear to be far more reasonable and well informed than much of the rest of the Motley Fool site. My complaint is not with him specifically, but with the principles espoused by Motley Fool in general.

Update: I stand by my assessment of the Motley Fool (that investors as a group would be better off without it and the rest of the stock newsletter industry). But I couldn’t have been more wrong about the contributions Brokamp would make to Get Rich Slowly. His articles have provided sound, helpful advice. Two examples:

• How Much Is Your 401(k) Costing You?
• Investing 101: How Diversification Reduces Risk

Let’s imagine a hypothetical group of 1,024 actively-managed funds. If we look at pre-expense results, roughly 50% of the funds should outperform the market each year. That means that after 7 years,

• 8 of the funds will have outperformed the market every year,
• 64 funds will have outperformed the market in at least 6/7 years, and
• 232 funds will have outperformed the market in at least 5/7 years.

And that’s based purely on luck. No need for any fund management skill at all.

According to the Investment Company Institute, at the beginning of 2002, there were 4,756 equity mutual funds. Using our numbers from above, we can see that pure luck would account for 1,077 different funds outperforming the market in at least 5 of the last 7 years on a pre-expense basis. There would even be 37 funds that would have outperformed in each of the last 7 years.

And yet, I suspect that most of us are inclined to think “wow, this guy is good!” when we see a fund with a record of beating the market for each of the last 7 years. Oops.

The simple fact that a fund manager has outperformed the relevant benchmark index doesn’t tell us very much at all.

What about extended periods of outperformance?

According to Jeremy Siegel (in Stocks for the Long Run), in order to be able to say with 95% confidence that a fund manager’s performance is due to skill rather than luck, he’d need to outperform the market by an average of 4% per year for roughly 15 years. (If the fund was only outperforming by 3% annually, it would take more than 20 years.)

The problem, however, is that by the time we’ve seen a fund manager outperform the market for 15 years in a row, it’s not particularly likely that he (or she) will be managing the fund for much longer.

So how should we choose funds then?

Of course, picking an actively-managed fund with a long-term record of outperformance is probably better than picking an actively-managed fund with a long-term record of underperformance. But don’t fall into the trap of assuming that a fund manager must be a genious simply because he’s beaten the market for the last several years.

Rather than focusing exclusively on past performance when choosing mutual funds, try doing the following:

• Look for low-costs,
• Look for low portfolio turnover, and
• Most importantly, make sure you understand what the fund is investing in.

1. Outperforming the market by picking stocks and/or market timing is rather difficult.
2. Less than 50% of actively-managed funds will beat a low-cost index fund.

So it seems to me that investing in an actively-managed fund is the rough equivalent of saying, “I don’t have an above-average ability to pick stocks, but surely I can do an above-average job at picking an actively-managed fund!”

Many investors–myself included for a few years–don’t seem to pick up on the fact that selecting an actively-managed fund must not be as easy as it looks–i.e., simply choosing a fund with great past performance.

If it were that easy, then everybody (including other fund managers) would already be doing it. And if that were to happen, then by definition the original outperforming fund could no longer be an above-average performer.

Takeaway: Just like with picking individual stocks, beating the market by picking actively-managed funds requires that you either:

1. Get lucky, or
2. Know something that the market doesn’t.

And I assure you, a fund’s past performance is never unknown to the rest of the market.

In  a comment on last week’s post about the psychological benefits of index funds, Kevin pointed out an article from Motley Fool arguing that the problem with index funds is that they don’t make any attempt to separate good companies from bad companies. And as a result, they end up investing in companies that perform poorly (like the financial sector over the last year).

The author of the article suggests that a strategy could be developed for running stocks in the S&P 500 through a number of mathematical equations to see which ones should be kept in the fund and which ones should be eliminated.

This type of strategy is known as quantitative analysis because it considers only mathematical (i.e., “quantitative”) factors when analyzing a company instead of including subjective criteria such as strength of management, brand name advantage, and so on.

The advantage: Low cost

To me, there’s one big potential advantage for quantitative strategies: Since they’re purely mathematical, they can be (almost) entirely automated. This allows for a fund using a quantitative analysis strategy to have far lower operating costs than a fund that uses teams of researchers to manually research companies before investing in them.

Not as low-cost as index funds

However, there’s no way that any actively managed fund–even one using an automated strategy–can have lower costs than a (Vanguard) index fund. Why? Two reasons.

First, a quantitatively-run fund needs data. Lots of it. Generally, this data comes at a price–whether paid for directly or paid for in terms of labor-hours from researchers.

Second, a quantitatively-run fund is (most likely) going to have higher portfolio turnover than an index fund. And as we’ve discussed before, portfolio turnover leads to significant (albeit unreported) expenses.

It worked once…but will it work again?

My second issue with quantitative strategies is that there’s no way to know for certain if they’ll work in the future. The fact that they worked in the past doesn’t necessarily mean anything.

Given that there’s a functionally infinite number of quantitative strategies an investor could use, there’s also a functionally infinite number of ones that would have outperformed an index over any given historical period. Look long enough and you’ll find one.

Look even longer, and you can find some that have worked historically, but are clearly nonsense. Example: U.S. stock market movements have been shown to have very high correlation to butter production in Bangladesh.

In the Motley Fool article, the author performs a backward-looking test to see how his strategy would have performed. And…surprise surprise! It beat an S&P 500 index fund.

My question: Was this the first quantitative strategy the author tried? Or did he also run the numbers for a handful of others which ended up underperforming the index?

As they say, we don’t call the man who won the jackpot at a slot machine an expert on probabilities. Similarly, the success of any given strategy over a particular historical period could have been purely luck. A strategy has to outperform the index for an extended period of time (think: multiple decades) before we can attribute it’s success to anything meaningful.

And even if it wasn’t luck…

…it’s entirely possible that some fundamental shift could occur that causes the strategy not to work as well in the future.

In summary

If you want to try to beat the market, a quantitative analysis fund could very well be your best bet. Personally, however, I’m going to be sticking with a strategy based on simple arithmetic–arithmetic that will apply over every extended period: Lower costs means greater returns.