When investing in the stock market, there are two types of investment fund manager that we can select. Firstly, we have the active managers. They are selecting certain shares from the market in the hope and expectation that they will be the companies that perform better than the broader market and provide investors with additional returns. The active managers will normally buy and sell these shares on an ongoing basis, trying to gain an advantage. We then have the passive managers (we prefer to call them ‘systematic’). This simply means that systematic managers, rather than selecting specific stocks, will buy the entire market (or a large part of it) in order to provide the market rate of return. Crucially, they can do this reliably and at low cost.
The survival of the fittest created rubbish investors
On the face of it, the active option seems more attractive. As humans we’re attracted to taking action. Those of our ancestors on the savannah who didn’t ‘fight or flight’ were eaten by lions! The survivors were the ones who took action, and either killed the lion or ran away. Unfortunately, these fight or flight instincts that we’ve inherited from our ancestors don’t make us good investors. Generally speaking, the more you mess with your investments, the worse you do. No matter how they dress it up, active managers are betting and gambling. Active management is an intellectual game with lots of bright people competing against lots of other bright people. Their message is that their skills will enable them to beat the market – but the data doesn’t back this up at all. The vast majority of active managers don’t beat the market. Due to the law of large numbers, in any given year there will be some active managers who do beat the market – but the bad news is that these winners don’t tend to repeat their successes.
Neil Woodford’s woes:
You’ve probably read about the ‘star’ manager Neil Woodford and the disastrous results of his flagship investment fund. Vast amounts of money were invested with Woodford on the back of a previously excellent track record. He made some significant bets that didn’t come off and there was a resulting stampede exiting from his fund. At the time of writing this article, investors have been locked in the fund and performance is pretty woeful. This may be an extreme example, but it highlights the extra layer of risk that an investor is taking on by trying to select winning active managers.
A better way:
We construct portfolios comprising 10 different types of assets and use managers who are able to deliver the market rate of return for each of those assets at a very low cost. It works really well. No betting or gambling here.