Do the best active managers know more?

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When I tell people about the seven-day race I ran in the Sahara last year, they ask questions. The most common one is, “Why?”1 A close second is, “How did you get all the water you needed?”

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Now, you’ve probably heard that you should drink eight glasses of water a day. It’s one of those bits of conventional wisdom that a lot of people just absorb along the way. But it turns out not to have a lot of data behind it.

There’s no formal recommendation for water intake. The eight-glass figure appears to come from a 1945 report recommending 2.5 liters a day. And even then, the report suggested much of that could come from food.2

Do the best active managers know more?

That’s how conventional wisdom often works. A widespread “fact” becomes so ingrained that it’s slow to change. Here’s another bit of conventional wisdom you might have heard: The less efficient that a market is, the more likely that an active manager will be able to outperform.

It makes sense at first glance. If there is less informational efficiency, the odds increase that a manager with an informational edge can consistently beat the market.

But just like our water example, we need to ask if there are data behind this idea.

What the data say

To test the conventional wisdom on active management, let’s examine active managers in U.S. small-cap equities and emerging markets equities. There’s a general belief in the industry these are easier segments of the market in which to outperform because there are more informational advantages available to active managers. So it seems reasonable to expect to find active funds that consistently outperform their peers over long periods.

The chart below tests that hypothesis. It shows the most recent five-year performance (from 2012 to 2016) of active funds that performed in the top quintile over the previous five-year period (from 2007 to 2011). Going by the conventional wisdom, we’d expect to see most of these funds remain on top.

Outperformance tends not to persist

Source: Vanguard

Note: Percentages do not add up to 100% due to rounding.

Instead, we see the opposite. The most common result for the top performers from 2007 to 2011 was to fall into the bottom quintile over the next five years. A significant number of funds ended up merged or liquidated in the five years following top-quintile performance.

The conventional wisdom does not hold.

Conventional wisdom can’t win the zero-sum game

Let’s take a step back and remember that the stock market is a zero-sum game.3 Every time an investor makes a profitable trade, another investor must take the opposite side and incur an equal loss. And investors are subject to costs to participate in the market.

While inefficient market sectors could offer informational advantages with attendant opportunities for outperformance, their participation costs (such as wider bid-ask spreads, market impact, and expense ratios) are significantly higher than in larger, more liquid areas of the market. Remember, you only keep after-cost returns.

With improvements in technology and rising competition, it is becoming increasingly difficult for active managers to consistently outperform relevant market indexes net of all costs. They’re no longer competing against “mom and pop.” They’re competing against the professionals in the neighboring skyscraper, and the ability to find an informational edge is shrinking along with their margins.

By Chris Tidmore of Vanguard, read the full article here.

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