Subscribe for 17¢ / day
Mark Thomas.JPG

Several years ago, my wife and I played "Heads or Tails" at the Chase Hawks Memorial Banquet in Billings. Four hundred people in attendance joined in the game, each standing with one hand placed on either their head (for heads) or bottom (for tails). The emcee flipped the coin and declared “heads." Those of us with our hands on our bottoms sat down, and those lucky enough to have their hands on their heads remained standing. We went through 10 rounds, ruthlessly eliminating half of all of the participants with each call. Even though more and more were eliminated, everyone was joyously engaged, especially since the winner would be going home with a brand new set of tires, donated by Tire-Rama of Billings.

Before we knew it the final coin flip was upon us, and up on stage stood my wife and one other gentleman. Both had made it through the gauntlet of all of the previous rounds. It was decision time, heads or bottoms. With nervous joy, my wife put her hands on her head. The emcee called heads again! My wife would be going home with the tires! Many of my friends argued that she had been lucky, and I agreed.

 I couldn’t help but think about this in the context of investing. For the investor, it begs the question, if my wife was lucky, and correctly bet 11 events in a row, why do we declare that the active mutual fund manager involved in placing bets on security selection, who beats the market 5 years running, is skilled and not merely ‘lucky?’

 But first, perhaps we should define active and passive money managers. Active money management believes that they can reasonably predict the future, select stocks based on predictions, and therefore benefit from their predictions. Passive money management does not believe this is possible, taking into account the cost of investing in research in order to enhance the probabilities of their bets.

Passive money management agrees that the active stock buyer is successful periodically, but their probability of success declines over an extended period of time and events. On the other hand, passive money management uses low cost index funds that replicate the market average.

According to the S&P Dow Jones Indices Research, “2013 was a stellar year for stocks as domestic equity markets posted double-digit returns…however; most active managers in the large and small cap categories underperformed their benchmarks. Over the last five years, 72 percent of all active large company managers underperformed the comparative benchmark of the Standard & Poor’s 500.”

The theory of probability suggests that after a series of events, there will always be a winner. Indeed, after 11 coin tosses, my wife won. If she were skilled, it would have been easy for us to forecast her outcome, as her actions would be predictable. However, most active managers underperform the index, therefore we cannot attribute success to skill. Hard work and intelligence may be at play, but doesn’t appear to contribute to skill. Herein lies the difficulty. By hiring an active manager, you are paying fees for a presumed skill. This skill feeds the fire of the investors hope. But it is difficult if not impossible to identify future winners and losers in mutual fund managers, just as it is in the game of Heads or Tails.

Another example can be found in the April 13, 2009 Forbes article, ‘Bad Guys.’ “For years, William Miller’s name appeared at the top list of the world’s most successful stock pickers. His Legg Mason Value Trust Mutual Fund outperformed the S&P 500 every single year for a decade and a half to 2005. After his hot hand cooled, the picture got very ugly. If the investor had made identical bets on the S&P 500 index fund over the past 26 years, their return would have been 5.8 percent versus the Value Trust of 5.4 percent.”

Some may disagree with me, as it’s both easy and comforting to believe that an investment guru can beat the market over and over again. At times belief is confirmed when news reports on winners who beat the benchmarks of last year. Most investors don’t think they possess sufficient skill and knowledge to invest on their own, so they rely on last year’s superstar. But when costs are deducted from the funds return, rarely does it meet a comparative benchmark. To be clear, I will never argue that a mutual fund manager will never beat the relative benchmark. Consider the Fidelity Magellan Fund manager, Peter Lynch, whose track record was put under academic scrutiny by Dartmouth professor Dr. Kenneth French. He mathematically established a convincing argument that Lynch beat the benchmark throughout his tenure at Magellan Fund.

We know that it has been done. However, since Peter Lynch retired we have seen Fidelity, with their admirable resources, go through multiple management changes at the Magellan Fund as they continue to search for the next manager who can beat the benchmark. If Fidelity is in search of a market guru, how can common investors believe that their odds are better than that of Fidelity’s?

The statistical probability is extremely low for an investor or investment advisor to pick in advance the best stock, ETF, or mutual fund for each category of risk built into a portfolio. Searching the 5,000-plus available mutual funds in order to select the best manager for U.S. large, small, and international companies, continue to narrow the probability of successful outcome relative to buying a low-cost index fund representing each of those categories.

I agree with the now retired Lynch when he states in his book ‘Beating the Street,’ “All the time and effort that people devote to picking the right fund, the hot hand, the great manager, have in most cases led to no advantage.” Warren Buffet, CEO of Berkshire Hathaway Inc. continues along the same line when he states in his 1996 letter to shareholders, “Most investors both institutional and individual, will find the best way to own common stocks is through index funds that charge minimal fees.”

For the long-term investor, one could benefit by spending more time understanding and controlling investment costs than trying to pick a hot hand. Index funds not only capture a well-diversified exposure to markets, they also achieve their benchmarks at a very low cost. While picking an investment guru or playing the game of Heads orTails may be a thrill, rarely do we find that it pays off in the long run.

Mark Thomas is the principal at Capstone Wealth Management in Billings.  He has provided professional investment management for financially established families for more than 25 years. 

0
0
0
0
0

Locations