Session 36 (of 42): More on Investor Performance - Continuity and Consistency

0:00 Hi, welcome back. Today is my second session on active versus passive investing. If you remember in the last session, we laid out the evidence that active money management at least collectively has underperformed. That most active money managers underperform the market. And that makes a case for passive investing in index funds and ETFs. Now, if you get pushback from active money managers, usually in the context of, "Hey, the average might be bad, but that's brought down by poor money managers. Where are the good money managers?" And that's some basis, right?

0:33 There's clearly a variation across money managers. Maybe the average is brought down by bad money managers who stay bad and that the good managers actually beat the market. So, in this session, I want to focus on the evidence on whether that's the case. And I'm going to give away the final finding. There's very little evidence at least across time and across different kinds of money managers of continuity of good money managers staying good and bad money managers staying bad.

1:00 There's some evidence of what's called a hot hand phenomenon. We'll talk about that. But it's passing. It's not long-term. In the long-term, there's very little evidence for the, you know, for for the for the statement of the argument at least that's the bad money managers who are causing the problem and the good money managers deliver value. So, to see the easiest way of seeing that there's no continuity is to do the following. It's called a transition probability.

1:27 And I'm going to show you how it's computed using this data from 2022 to 2024. Basically, at the start of every year, you break mutual funds down based on performance from top quartile to bottom quartile. Quartile one are the best. And quartile four four are the worst. So, you break money managers down. Then you track what they do in the next year or the next period, whatever that period, and see what quartile they fall in. world in which the best money managers stay the best, you should see the transition probability for quartile one to quartile one to be a very high number, 40, 50, 60, in a perfect world, 100%. And bad money managers stay bad, the quartile four managers will stay in quartile four.

2:13 In this table, you can make your own judgments, but 25% is randomness. That would be if you had in any given year, the reason you were in the top was the core the bottom was pure luck. Then the next year, you should have about a 25% chance. Let's take a look at some of the boxes at least. 25.5% of the managers in the top quartile stay in the top quartile. Only 10.6% of the managers in the bottom quartile stay in the bottom quartile, but here's the catch. This study also looked at what happens to some of the funds that didn't make it. They get merged or liquidated, and you can see it's that number is not 0%.

2:55 Overall, if you look at these statistics, there is very little evidence of continuity. In fact, you could argue that there's stronger evidence of dramatic shifts from one end of the spectrum to another, that quartile one stocks have a higher chance of ending our quartile five one funds and have a higher chance of ending in the very bottom of the pile rather than the top of the pile. And there's intuitively reason for that, right? If you're a high-risk money manager, you go for big stakes, you concentrate your portfolio. When you are right, you will be at the top. When you're wrong, you're going to be at the bottom.

3:30 Now, to support investors in the face of all of this bad mutual fund performance, there have been services that have come out that rank mutual funds. Perhaps what the best known is Morningstar, which gives mutual funds stars from five stars if you're the very best to one star. And there are there are people who invest based on Morningstar ratings, arguing that Morningstar ratings are high, these are good funds. This fairly early study Morningstar ratings looks at whether there's predictive power in these ratings.

4:04 The highest performing funds actually underperformed the market by about 1 and 1/2%. The lowest performing funds clearly underperformed the market by a lot more. So, at a very generic level, there is some information. But as a investor, if I said, "Look, I'd want to use this to pick funds." It's very noisy information because outside of that very lowest ranking funds, it's very difficult to find a pattern here that you can invest based on. Now, Morningstar has revamped its rankings over time trying to make them better and it's it's made some improvements. Instead of having four large groups like it did prior to 2002, now it's 48 smaller subgroups that these stars are based on.

4:47 The risk measures are much more complete now to capture the downside risk. And then you have a fund with multiple classes, it's consolidated as one fund rather than be treated as separate funds. And they do have some predictive power, at least this study, but it's it's mild. The higher rated funds earn higher returns than the lower rated funds. But they often have higher fees as well and that's and if you adjust for those fees, it's unclear whether those higher returns persist.

5:16 So, there's no persistence or no continuity in rank in in performance and the rank the the services that rank mutual funds don't do that great a job of separating the great from the good to the average and the bad. But here comes the one piece of evidence with mutual funds that might be interesting to investors. And this is a something that was uncovered about 20 or 25 years ago by researchers. They discovered there was this phenomenon of a hot hand. What does that mean?

5:46 That winners stayed winners at least in the near term. So, the way to read this is this were truly random, the percentage of repeat winners should be 50% and if you beat 50% by enough, you're statistically deviating from randomness. So, if you take a year like 1975 where 74.4% of winners from the previous year repeated, you had clearly a violation of randomness. That's a hot hand phenomenon. And that hot hand phenomenon persists across both small and large funds. It's not just the biggest funds or the smallest funds, there seems to be persistence. Persistence in what sense?

6:25 We look at the des- if you break down these funds based on excess returns in the prior year, they continue to earn excess returns in the next year. So, rather than use Morningstar ratings, you could probably look at the performance last year if you believe in the hot hands phenomenon, you're at least going to make higher returns for the next year, but the hot hands become much cooler if you extend out the time period. So, active money management's very difficult to make a case for active money management collectively, either in the aggregate or even as individual money managers. So, the question is why do active money managers fail? Why with all these resources are they unable to beat the market?

7:05 I can I can point to five factors. First is transactions costs. Very high transactions costs and I'll show you the evidence in transactions costs and while active money managers have become better at controlling transactions costs, guess who they're competing with? Index funds, which have almost no transactions costs. The second is and this cuts to the heart of this class is I'm going to argue that most active money managers have no core investment philosophy. They have strategies. They chase the strategy that worked the best last year and that means you're often shifting your portfolio with higher transactions costs, higher turnover.

7:42 Too much activity. In fact, you could argue both the transactions costs and too much activity come from having no core core philosophy. You trade too much. And many of them try to time markets at least implicitly by pulling money out of equities, holding it in cash when they think the market's going to go down. And putting more money back in the market when the market they think the market's going to go up. They They're just not great market timers.

8:07 And finally, there are behavioral issues that come from how how they get judged as active money managers. You're saying, "What are you talking about?" If you're a mutual fund manager, the way you get judged is not against the market or against what I would expect you to make. It's against other mutual fund managers who practice your craft. To emerge as a hero, then all you got to do is be better than the rest of those people you compete with, which leads I think to a lot of herd mentality. Which is doing what everybody else is doing because you're less likely to get get get yourself into trouble.

8:44 So, let's take those issues. Let's take the transactions costs. You As I said, now active money managers have become better at controlling costs. If you take active money managers for instance, a 1% transaction cost at the end of the '90s is now down to about 0.7%. That's good. Transactions costs for active money managers have dropped. But guess who you're competing against? Not other active money managers, but passive investors whose transactions costs have also dropped down to close to zero.

9:15 So, on a transactions cost basis, that's a That's a barrier to beating the market is this collective cost. In fact, Bill Sharpe, long time ago, made the argument that collectively active money managers have to beat the market. Have No, I have to underperform the market because they collectively have transactions costs, which means it's going to be a drain on their return. Second is the more turnover you see in in an actively run fund, the worse the returns going to be. So, in this graph, for instance, we know you funds were broken down from lowest turnover ratios to highest turnover reflecting how much they trade.

9:56 And the the first column is actually the total return, right? Prior to prior to adjusting for risk and transaction. And then you look at the excess returns and you can see that the excess returns become more and more negative the more you trade. In fact, the trading cost, which is basically reflection of the last graph, the trading cost tend to rise and the highest trading cost funds have a much tougher time matching up to the market.

10:23 So, when you look at a fund rather than look at Morningstar's Morningstar's stars for the fund or even last year's performance, maybe the key variable you should look at is the trading cost number. If that number is high, history suggests you should avoid the fund. The lower that number, the greater the chance the fund has of actually beating the market. And a related issue, the more you trade, the higher your tax burden. And we talked about this in the context of tax cost very early in this class.

10:56 If you look at the five largest index funds and compare them to the 10 largest active funds, the difference between pre-tax and post-tax returns to investors is much smaller in index funds. You face a much smaller burden. So, in addition to index funds kind of doing better than active money managers even before taxes, after taxes that difference becomes even larger. Second, as I said, there seems to be no core philosophy. One of the ways you can measure how much drift there is is, you know, S&P maintains this database of how funds drift from one style to another. By looking at what they invest in. So, if you say you're a large cap fund and you start buying small cap stocks, you you've drifted in style.

11:42 See the the pi- the pie chart in the orange portion? That's the portion of invest- of mutual fund managers who drifted away from their starting description. The only two groups where managers for the most part stayed in their lane in their original style is emerging market funds. It's kind of difficult to shift away from emerging markets without giving away the game and international small cap funds. In every other grouping, more than 50% of fund managers shifted away, did not stay consistent with their original style.

12:18 We talked about too much activity. There was a very interesting and a very telling study about what activity does to active money managers. And what this study looked at is what the returns on mutual funds would have been if their portfolios had been frozen in what they owned on January 1st of each year compared to what they actually generated with all the money managers showing up every day and doing what they did during the course of the year, all that activity.

12:45 And it found that for the most part, these funds would have been better off leaving their portfolio untouched rather than having all the activity that they did during the course of the year. Activity for the most part hurts money managers and the more active you are, the tougher it becomes to beat the market. As for the failure to stay invested, the defense that equity fund managers will give you is we're trying to time the market. And in this graph, which looks at six market downturns, we look at how well active equity mutual fund managers have done in protecting their clients from downturns.

13:22 1987, it's true, active and perhaps because it happened so quickly, active fund managers did deliver a slightly less negative return but in one, two, three, four of the downturns active money managers actually had more negative returns during a downturn. So if their sales pitch is, "We protect you in the next downturn." It's history suggests it's not happening. One final factor and this is the behavioral factors. There's a lack of consistency issue. We talked about this and that lack of consistency coming from the fact that you don't have a core philosophy means you have higher expense ratios, more trading, higher taxes.

14:02 Lot of herd behavior. You're better off as a fund manager doing what everybody else is doing and even if you fail, you're not going to lose your job whereas if you're the outsider, the contrarian doing something different and you fail, you're more likely to be fired. There's a lot of window dressing. You want to make yourself look good rather than actually doing good. So you see this towards the end of every quarter where mutual fund managers get rid of their losers and try to load up on winners even though it's too late to actually win on those winners. Lot of window dressing.

14:35 So what's the bottom line? If you look at the research on market inefficiencies, it seems like there are so many inefficiencies you can take advantage of to beat the market. On paper it's easy to beat the market. In practice though when you look at professional money managers who are using exactly those same inefficiencies trying to exploit them it turns out much more difficult for them. In fact, they underperform the market. So the question is what is it that's causing the slip between the cup and the lip? And what you see on paper and what gets delivered.

15:08 And I think it's a reflection of in addition to transactions, costs, and taxes which are very real issues. Even if you bring them in, it's a reflection of the fact that it's much more difficult to execute many of these strategies that look good on paper than it looks on paper. And that's part of the reason why the right end game for many people in markets might be to invest your money in an index. Incidentally, remember the greatest value investor of all time, Warren Buffett, gives exactly this advice to a lot of people who come to the Berkshire Hathaway meetings. He tells them, "Look, if I were starting today, I'd probably put more of my money or all of my money in an index rather than do what I did because the world has changed, the market has changed."

15:54 It's a testimonial to how much more difficult it's become to win at the active investing game. If you're an active investor, I hope I haven't depressed you too much, but the way I would describe this is this is a very tough game to win. And if you embark on beating the market, recognize that the odds are against you, and you've got to work really hard, create a competitive advantage that actually stays sustained to beat the market. I hope you pull it off.

16:22 And I hope you found this session useful. Thank you very much for listening.