One way to reach past the daunting complexity of investment management as a whole would be to break it into parts and concentrate on “solving” the complex puzzle one part at a time.
In the past quarter century, investors and investment managers have enjoyed a long bull market and splendid absolute performance, but relative performance has become worse and worse—and worse. That's why the Money Game (‘Adam Smith's’ delightful title for the adventures of performance investors in the 1960s) has become increasingly the Loser's Game (my less sanguine article title in 1975).
A large majority of professionally managed funds underperform the market index, particularly when cumulative performance is measured over longer periods of time. Over the past 50 years, mutual funds in the aggregate have lost 180 basis points compounded annually to the S&P index, returning 11.8% versus 13.6% for the index. Over the past decade, S&P 500 returns have been better than the results of 89% of all U.S. mutual funds. The average “underperformance” of mutual funds is reported to be 340 basis points. And the “professional shortfall” is found in international markets as well.
Of course, there is the possibility, even probability, of some “end-period dominance,” since fewer than a dozen large stocks with high P/E multiples have given the S&P index an extra lift, and most active managers fare better when the stock market broadens out. Serious students of investing, though, would be wise not to dismiss the evidence too quickly. Relative to the market averages, investment managers' long-term performance highs have been lower and their lows lower than they were a generation ago.
Why are the results of the efforts of so many hard-working, experienced, and talented professionals with so much data, information, and expert advice available to them so disappointing? Partly, in recent years, the shortfall has been magnified by the poor performance of and the overweighting of small-cap stocks in most professionals' portfolios. Partly, it has been due to strong price appreciation and the underweighting of a few large-cap stocks. (These parts of the shortfall can be expected to reverse as market returns revert toward average long-term experience.) And partly it's due to cash drag because managers, rightly or wrongly, carry cash positions. But these partial explanations should not distract us from recognizing the grim realities of the active investor's position.
The main reason managers' results are so very disappointing is that the competitive environment within which they work has changed from quite favorable to seriously adverse and it is getting worse and worse. Those inclined to dismiss dinosaurs should remember that those beasts roamed the Earth for over 100 million years before their climate changed from favorable to adverse. Professional investment management is now in a very different climate from that of just 30 years ago.
Before examining the change in climate, let's remind ourselves that active investing is at the margin always a zero-sum game. To achieve superior results through active management, you depend directly on the mistakes and blunders of others. Others must be acting as though they are willing to lose so you can win, after covering all your costs of operation.
In the 1960s, when institutions did only 10% of the public trading on the NYSE, and individual investors did 90%, large numbers of amateurs were, realistically, bound to lose to the professionals.
Individual investors usually buy for reasons outside the stock market: They inherit money, get a special bonus, sell a house, or have money as a result of something else that has no connection to the stock market. They sell because a child is going off to college, or they have decided to buy a home—again, for reasons outside the stock market. Individual investors typically do not do extensive comparison shopping across the many alternatives within the stock market. Most individual investors are not experts on even a few companies. Many rely on retail stockbrokers who are seldom experts either.
Individuals may think they know something when they invest, but almost always, what they think they know is either not true or not relevant or is already known by the professionals in the market. Their activity is not driven by investment information that comes out of market analysis or company research or rigorous valuation. The activity of most individual investors is what academics correctly call informationless “noise” trading.
So, it is little wonder that professional investors—who are always working inside the market, making rigorous comparisons of price-to-value across hundreds and hundreds of different stocks on which they can command extensive, up-to-the-minute information—thought they would outperform the individual investors who used to dominate the stock market and do 90% of all the trading. The professionals could and did outperform the amateurs.
But that was a generation ago. The picture is profoundly different now. After just 30 years, the former 90:10 ratio has been completely reversed—and the consequences are profound. Today, 90% of all NYSE trading is by professionals. In fact, 75% of all the trading is by the professionals at the 100 largest and most active institutions—and 50% is by the professionals at the 50 largest and most active institutions. And what a crowd of professionals they are! Top of their class in college and at graduate school, they are “the best and the brightest,” supplied with extraordinary information, disciplined and rational; they are very highly motivated. They make errors, but they will make fewer and fewer of them—less and less often. And the errors they make are corrected more and more quickly.
Think about it further: most professionals are not beating the market because such skilled and unrelenting professionals are the market and they cannot beat themselves. The professionals' big problem is that they are no longer buying from and selling to the amateurs. There are not enough amateurs around. The professionals have to buy from and sell to other professionals—usually the most active and aggressive institutions. They all play to win.
The result is that active investing almost always either produces too little reward or costs too much, or both. (And this ignores the cost of taxes paid by shareholders in high-turnover mutual funds.) The overall climate for active investors has changed from hospitable to hostile and it won't go back.
To put all this into a different perspective, investment management can be divided into two parts. One part is the profession and the other part is the business. We all know the business part: business is booming. Fee schedules are up threefold in one generation, and assets have mushroomed as much as tenfold—and we all know how to multiply. (Public valuations further multiply the multiples of earnings.) “Too much of a good thing,” to quote Mae West, “is wunnerful.”
But performance on the professional dimension is not nearly so encouraging. As a profession, investment management can be further divided into two realms: one micro, and one macro. On the micro or craft level of analyzing securities, the profession clearly continues to progress remarkably. Analysts and fund managers at investing institutions enjoy and know how to use their extraordinary electronic access to extensive data and sophisticated interpretations by industry experts who are on call virtually all the time with detailed knowledge they organize and explain within a global context. Practitioners of the craft are well paid and highly skilled. Research and portfolio management have never been better.
Then there is the macro level of investment counseling. Working efficiently, as Peter Drucker has explained, means knowing how to do things the right way, but working effectively means doing the right things. Investment counseling helps investors do the right things. The investment counselor's main professional work is to help each client identify, understand, and commit consistently and continually to long-term investment objectives that are both realistic in the capital markets and appropriate to the objectives of the particular client.
The hardest work is not figuring out the optimal investment policy; the hardest work is staying committed to sound investment policy and to maintaining what Disraeli called “constancy to purpose.” Being rational in an emotional environment ain't easy. Holding on to sound policy through thick and thin is extraordinarily difficult and extraordinarily important work. The cost of infidelity can be very high.
One example of the danger of emotion—driven by short-term misunderstanding and misinterpretation of stock market price data—has been quite costly for mutual fund investors. In the past 15-year, very favorable stock market, the average mutual fund gained 15% annually, but the average mutual fund investor gained only 10%. Fully one-third of investors' available return was lost by switching from one fund to another fund and all too often selling low and buying high.
Sustaining a long-term focus at either market highs or market lows is notoriously hard. In either case emotions are strong, and current market action appears most demanding of change, because the apparent “facts” seem most compelling at market highs and at market lows. This is why there is enduring truth to Pogo's statement: “We have met the enemy. and it is us.” This is why investors can benefit so much from sound investment counseling.
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While most investors take investment services offered in a conventionally blended form, it is possible to unbundle services into separate levels. There are five levels of decisions for each investor to make:
The least costly and the most surely valuable service the profession can offer is the very first level: getting it basically right on long-term goals and basic asset mix, often helped by wise investment counseling. The last two levels—the active management of managers (through hiring and firing) and the active management of portfolios (through buying and selling)—are simultaneously the most expensive and the least assured of success.
At Level One—setting realistic long-term investment objectives—every investor can be a winner, but as the accumulation of evidence makes increasingly clear, very few can or will win in the increasingly hyperactive and counterproductive pursuit of competitive advantage on Level Five.
That's the ultimate irony of the Loser's Game: We can be dazzled by the excitement and the action, and striving to win on Level Five where the costs to play are so high and the rewards so small. Even worse, the search for ways to beat the market distracts us from focus on Level One, where the costs are low and the rewards can be quite large.
As a profession, shouldn't we be encouraging our clients to focus less of their attention on Levels Four and Five, where the 90:10 shift to 10:90 has so profoundly and adversely changed the environment; and more on Level One, where the changed environment does no harm and actually makes strategy and policy both easier to implement and more sure to produce the expected or intended results?
Source: Journal of Portfolio Management, Winter, 2000.