February 22, 2016

Swedroe: Don’t Buy Winners

For almost five decades, the literature on the investment performance of mutual funds has found that very few managers possess sufficient stock-picking or market-timing talent to allow them to consistently and reliably produce positive risk-adjusted performance after considering their fees. In other words, there’s little to no evidence of outperformance beyond the randomly expected.

As my co-author Andrew Berkin and I discuss in our book, “The Incredible Shrinking Alpha,” while perhaps disheartening, this result shouldn’t be surprising given the very high skill level of active managers competing fiercely in a zero-sum game, even before expenses. Thus, investors shouldn’t expect there to be many opportunities for a free lunch.

In addition, because we should expect the scarce resource to earn any “excess returns” that occur (and the ability to generate alpha is far more scarce than investment capital), it is naive to expect that mutual fund managers won’t charge sufficient fees or attract a sufficiently large amount of assets to effectively capture any alpha they generate. Said another way, investors should not expect to be the beneficiaries of the manager’s skill.

Despite the large body of evidence demonstrating that it’s a loser’s game (one that, while possible to win, has odds so poor that it’s not prudent to try), the most common strategy used by both institutional (such as pension plans and endowments) and individual investors to select a fund manager involves hiring outperforming managers and firing underperforming ones.

Read more at http://www.etf.com/sections/index-investor-corner/swedroe-dont-buy-winners

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