There are hundreds of thousands of money managers in the world, and it’s a mark of how few of them manage to deliver consistently strong performance that those who do so are household names.
Warren Buffett, of course, is the name repeated most often, while here in Britain the fund industry’s blue-eye boy is Neil Woodford.
Time and again proponents of active management cite the success of managers like Buffett and Woodford as an argument in favour of using active funds. It isn’t just that the claim is tired and lazy; it’s also completely illogical.
It is, after all, their very rarity value that makes Buffett and Woodford so well-known. Over meaningful periods of time, only a tiny fraction of active managers are able to beat their benchmark indices net of costs, and both Buffett and Woodford have shown that they belong in that group.
There’s a much more fundamental issue here, though, and it’s this. Anyone can look back and identify the best-performing funds over the past five, ten or 20 years. But to be a successful active investor you need to identify star managers in advance, before they start delivering market-beating returns.
Identifying a winning fund prospectively is notoriously difficult. According to Keith Cuthbertson, a Cass Business School professor who’s spent many years studying the subject, future stars are “harder to find than the Higgs boson”.
Past performance is no guide to future performance, and the most persistent characteristic of fund returns is a lack of persistence. The recent winners, which are generally the ones that attract the most media attention, are often just the funds to avoid. That’s partly down to the fact that investment styles go in and out of fashion, but it also reflects the importance of random chance; in other words, a manager who was lucky last time round often finds that his luck runs out the next. One study calculated that it takes 22 years of data to be 90% certain that a manager is genuinely skilled.
Nor is there any certainty that the likes of Buffett and Woodford, who’ve shown that they possess the skill to outperform consistently in the past, will continue to do so in years to come. Both have dropped almighty clangers from time to time — Buffett, for instance, recently lost $444 million on Tesco, Woodford £120 million on Northwest Biotherapeutics — and both have suffered periods of underperformance, sometimes prolonged. No one knows how they their net returns will measure up to passively managed funds in the future, especially now that the the cost of index funds and ETFs has fallen dramatically (and continues to do so).
Of course there’s no shortage of people claiming to have the ability to pick future stars. I’m sometimes contacted by financial advisers, for example, who claim that they have systems in place to identify the next outperformers, and that, over the years, they’ve somehow managed to single out the market-beating funds.
That is some claim to make. How many advisers honestly identified Neil Woodford as a star and entrusted him with their clients’ money before he was famous? Did those same advisers also keep their faith in him (and persuade their clients to do so) around the turn of the Millennium, when Woodford’s performance was so pronounced that he came close to losing his job?
Even if they did pick Woodford early on and stick with him throughout, so what? UK equities (the field that Woodford operates in) is a very small part of the global investing landscape. Investors need balanced portfolios, broadly diversified across different asset classes and geographical regions. Are those advisers seriously saying that they managed to spot in advance the very few funds which have consistently outperformed in every single category?
If there really is an adviser out there who has seriously managed to do that over a period of 30 years or more — and are willing to provide they evidence to prove it — they truly possess something extremely valuable. But until anyone does produce that evidence, I’m sorry, I don’t believe it. There may not be a single adviser with a record that long who can genuinely say that their clients would not have been better off simply buying and holding a diversified portfolio of passively managed funds.
To quote Buffett himself, “When the dumb investor realises how dumb he is and buys a low-cost index fund, he becomes smarter than the smartest investors.” And, he may have added, the smartest advisers too.