Percentage of Active Fund Managers That Can Beat the Market Shrinking Rapidly

By Matthew Hougan

The percentage of active fund managers that can beat the market is shrinking rapidly.

There's a great article in today's New York Times by Mark Hulbert detailing a new research study titled "False Discoveries in Mutual fund Performance: Measuring Luck in Estimating Alphas."

The Times doesn't include a link, but you can download the full research study from the University of Pennsylvania here.

The research piece is written by Laurent Barras, Olivier Scaillet and Russ Wermers. It examines the historical performance of active fund managers and uses a statistical technique called the "False Discovery Rate" to suss out funds that beat the market out of "luck" from funds that beat the market out of real active manager skill.

One key finding relayed by Hulbert's is that the percentage of active managers beating the market is shrinking ... rapidly. If you had applied the False Discovery Rate in 1990, you would have found that 14.4% of all managers had genuine stock-picking abilities that allowed them to beat the market. But when you study managers in 2006, that number drops to just 0.6%!!!

The authors provide three potential explanations for this dip in performance: 1) high fees; 2) all the skilled active managers have been hired away to run hedge funds; 3) the market has become more efficient.

I don't agree with point #1, as managers in the 1990s also had to deal with fees. Point two is a possibility, given the huge growth in the hedge fund industry. But point number three seems like a real answer, given all the changes in the markets over the past 16 years: the rise of the Internet and real-time data; Regulation FD; etc.

Here's the lesson investors should draw from this: If you own an actively managed fund that has been beating the market, you probably ought to sell it before things revert to the mean. Chances are, your manager is no Peter Lynch. In fact, according to this study, Peter Lynch couldn't exist today.

Comments

[Daniel Demetri:]

I disagree. I think it's point 2. You have to prove persistence in mutual fund returns to conclude that the Interent (especially its real-time data abilities) has rendered the market for mutual funds more efficient. I don't believe that many mutual fund investors look at much other than past returns and the Morningstar Value/Size rank.

The market for asset mangers is becoming more efficient, but the market for mutual funds is probably not.

2008 Jul 14 05:05 PM

[index5:]

I just sold all my index funds today (14/2008). Have been in the market, was about 65% equities, which was all index funds. Performance YTD was about the the exact same as S&P, even with 35% cash (due to mix). So wasn't loosing too much.

Now I am 100% cash. Betting on a further crash.. but now have a feeling I shouldn't have sold, too late to cancel the orders. Any opinions?

2008 Jul 14 06:31 PM

[Lil Davy:]

To index5: how high can a dead cat bounce while heading for the bottom of the Grand Canyon?
Prediction is hard, but risk is certainly high. Have no regrets - you will live to fight another day.
I'm tempted to buy emerging market value names and sell off commodities plays... but I'm a speculator...

2008 Jul 14 06:52 PM

[index5:]

Thanks Mrzin. Hope your right. With cash, there certainly will be future opportunities (assuming my money market stays in business!). Its just that I was hoping to have a sense of relief - "now I'm not in the market" so can't loose. Problem is, now I find myself instead feeling "now I'm not in the market, need to worry about what/when to buy". So hasn't offered peace of mind I hoped. Also, anytime I sell, probably means the rest of y'all should buy. Capitulation 101 from a small time investor.

2008 Jul 14 08:03 PM

[User 226649:]

To index 5: Getting out of the market is one of the mistakes most investors make. Get back in and don't try to time it. 94.6% of your investment returns will be determined by your asset allocation. You were wise to choose index funds. Take a look at ETFs and put a diversified portfolio that consist of stocks, bonds, and cash and non market corrolative investments and stay in the market. How else are you going to get the returns that free markets provide?

2008 Jul 15 12:18 PM

[felipemass:]

Perhaps Peter Lynch never existed based on this. How about Ken Heebner and CGMFX or Soros or Rogers or Buffett, did they exist?

Why not go back and say the market is always priced correctly according to the Efficient Market Theory clowns.

Buy gold, oil and natural gas or Ken Heebner.

Oversold markets in a Bear market can get more oversold.

2008 Jul 15 01:21 PM