Index vs. Stock-Picking Styles.

Really all the result tells us is that most people perform lower than average – in the case of fund managers there is a plethora of participants in that business who simply do not add value. In many cases even if their pre-fees performance is better than the market average, their rate of fees reduces the return to the investor to less-than-average.

In the case of New Zealand fund managers it is an even more daunting task to beat the market. That is because unlike individual long-term investors they are, apart from the very special case of index investing, compelled to pay income tax on the realised capital gains from their share sales.

So it is hardly surprising that investment gurus like Warren Buffet maintain that the ‘dumb’ money should buy the index. That advice makes sense – if the additional investment of effort to lift returns into the top 10% is too much for a particular investor they should settle for lower-than-average returns by investing in a minimal cost index fund.

But those seeking better-than-average returns should not despair at this reality. Securing above-average returns simply requires effort – like most things in life. And the data tells us that only 25% of the market (and 10% of professional managers!) make sufficient effort to reap that reward. Actually to be fair to professional managers, they have to charge clients fees for the effort they exert, and this is why only 10% return to the client better-than-average returns. There’s reason to expect professional fund managers to achieve better-than-average returns at least as often as the market (25% of the time) but it’s the fees that lower the chance of them adding value to the client’s portfolio so often.

So for the individual investor, pursuit of better-than-average returns comes down to how much effort you’re prepared to put in, in terms of gaining the knowledge to add value. That of course depends amongst other things, upon the ‘opportunity cost’ of your time – what else would you be doing? If the answer is that the size of the management fee you effectively pay yourself for being active (about 1% pa typically) is a handsome wage for you, then it’s worth the effort isn’t it?

There is an argument that if we were all index-huggers the market would be a mindless, big-is-better pricing machine that would soon collapse under the weight of such irrationality. The argument is pretty well right. The reality though is that index investment managers still command a small portion of the funds invested in markets. There have been times – and studies show us – where the influx of money into index funds have pushed the market simply under weight of money rather than rationality of pricing. Thankfully those episodes have historically at least, soon corrected.

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