To answer that question, Hansi Mehrotra, founder of Money Hans, tackles and answers another: Is it possible for any investor to outperform a market index?
Let’s imagine the market is composed of only two stocks of equal size and value, A and B. In a given year, Stock A’s price increases by 20% and B’s falls by 20%. The total performance of the market index is the average of the two stocks: 0%. As active investors, we could have picked Stock A and invested all or most of our money in it. And we could have added more value by shorting Stock B.
Of course, with only two stocks to choose from, we have a very limited number of potential decisions. But what if there were 5,000 stocks and they each yielded a roughly 15% return? Then, even if we did the research, the lack of dispersion of returns would mean we couldn’t add value. So for active investors to have a chance to succeed, performance among securities has to vary widely.
Therefore, a rough gauge of whether active can outperform — of the active opportunity — is the number of securities available in a given market, the dispersion between the best- and worst-performing among them, and the proportion of retail versus professional investors. Big equities markets like those in the U.S. or India have more than 3,000 listed stocks with huge dispersions between them. So active investors do have plenty of opportunities to add value.
But the number of securities and the dispersion between the best- and worst-performing varies from market to market and from type of security to type of security, whether equities, fixed income, private equity, real estate, or something else. So not all markets are equal. Indeed, in some, the active opportunity may be close to zero.
Adherents on each side quote the statistics on how many active funds have outperformed their respective market indices and how long they were able to maintain that outperformance.
But what do their analyses prove? Just because most funds don’t outperform doesn’t mean picking funds is an impossible or meritless endeavor. It just means it’s hard. Otherwise, what would research houses and investment consultants offer as value propositions?
Fund pickers also know that active funds have to choose an “investment style” to express their investment philosophy. That style will necessarily underperform at times. If it didn’t, if the market didn’t go against it every now and then, there would be few opportunities for stock selection within that style.
Active investors and active funds can outperform the market, but different investors have different abilities. Few of us can pick outperforming stocks and funds in advance. And for those that succeed, reversion to the mean eventually brings them back down to earth.
Ask yourself:
- Can I pick good funds with the time and information I have?
- Can I trust my financial adviser / myself to have the right expertise, access, and incentives to select good funds for me or my clients?
- Can I monitor the funds on an ongoing basis, changing the funds when necessary, such that any outperformance is not negated by the associated costs?
If the answer to any of these is no, then we should consider going passive.
At the very least, by contemplating these questions, we have taken a considered, deliberate, and intentional approach.
This answer has been extracted from What most Active vs. Passive debates miss. You can read the detailed post there.