Are Elite Portfolio Managers Better Than An Index Fund?
Billionaires, giant pension companies, and uber-wealthy politicians don't hire financial planners like me.
They hire economic Ph.D.s and quant mathematicians because they'll pour over the most minute details of random small companies you've never heard of to gain an edge over their competitors.
You might be wondering if these elite strategies are available for us normal investors?
Before we answer that question, let's ask ourselves a better question which is do their results actually stack up?
WHAT THE RESEARCH SUGGESTS
To understand the results of the returns elite asset managers have generated for their ultra-wealthy clients, we can look to a recent July 2021 working paper from the National Bureau of Economic Research.
Selling Fast And Buying Slow: Heuristics And Trading Performance Of Institutional Investors
The researchers looked at 783 portfolios averaging $573 million based on a dataset comprised of ~ 4,400,000 trades from 2000 to 2016.
What they found was evidence that portfolio managers showed skill in buying stocks. They measured this by looking at the portfolio manager's buy trades and then comparing a hypothetical scenario that modeled buying the same amounts in randomly selected stocks, i.e., if a monkey were throwing darts at a dartboard.
Turns out these elite portfolio managers beat the dart-throwing monkies by 1.2% over time. Nice! That certainly justifies the fees.
However, if a portfolio manager is going to attempt to actively manage a portfolio in an attempt to outperform a randomly selected basket of stocks, i.e., an index, they must not only time the buy trades correctly but also the sells.
This is where the elite portfolio managers came up short.
When selling stocks, portfolio managers were worse than the monkey. In fact, portfolio managers underperformed the sell side of the trades by 0.8%, on average.
Ok, so why are fancy portfolio managers good at buying stocks but bad at selling them?
The big words and complicated phrasing in the research paper can be boiled down to a relatively simple behavioral concept; they lack feedback on the sell trades and don't learn as well from their previous mistakes.
When you buy a stock, you can watch its performance. Whether it appreciates or depreciates is irrelevant. What matters is you're vested in how it performs. Mistakes and victories are tangible, making it easier to learn from observable outcomes.
However, once you sell a stock, it's gone. Because it disappears from your radar, it's much harder to process what would've happened if you had sold sooner or held onto the stock longer.
WHAT THIS ALL MEANS
We can draw a few conclusions from the research as it relates to our own investing journey.
First, you're not missing out on something better. Just because you don't have $573 million doesn't mean you're getting shafted compared to your friend that owns a yacht with a helipad.
Second, it tells us that the best of the best are still human. Despite their talent and motivation, elite portfolio managers still screw up. The Harvard-educated portfolio managers, massive research teams, and fancy offices in big cities are a lot of show for zero value after fees.
Last, we would all be better off as investors if we let a top-notch portfolio manager buy our stocks but we allowed a robot to direct our sell trades. Although we have computer algorithms to suggest trades, there is no mechanism to combine human-directed buy orders with computer-generated sell orders exactly as defined in the research paper. Yet...
I get pitched all kinds of investment strategies multiple times a week. They all sound great.
We manage $35 billion for institutional clients and have a track record of capturing market returns on the way up while limiting losses on the way down.
Or something like that...
So many times I've gotten sucked into investigating these marketing ploys. They sound great, and don't I have the duty to my clients to get them the best return possible?
What I've found is that there is no perfect investment. There is always some combination of insanely high fees, illiquidity, inconsistent track records, etc. The financial industry is really good at telling you how good they are without actually being that good.
No one beats the market over long periods of time because no one can accurately predict ups and downs with consistency. If they could, does it make sense they'd share this with the world?
The best advice I've found most effective in generating wealth over time is to accept the market return. The most efficient mechanism to capture the market return is index funds.
The mutual funds and exchange-traded funds (ETFs) we implement for clients are designed to mirror the benchmark indices (where the name index fund comes from). Over the years, I've witnessed this low-cost, tax-efficient phenomenon play out.
The best part of combining index funds with a rebalancing strategy is that our portfolios have behaved as expected.
It is a difficult thing to bring certainty to a financial plan. Instead of trying to outguess millions of other investors, recklessly swinging for the fences, or hiring some elite portfolio manager, I'm going to stick with what's worked.