Why Money Managers Fail to Beat the Market

by Alexander Green, Investment U’s Chief Investment Strategist
Monday, June 27, 2011: Issue #1543

Here are three easy ways to beat the market: Deception, irrelevance and bad math.

Perhaps some explanation is in order…

It’s a well-known fact that three out of four investment professionals fail to beat an unmanaged index each year. Over the long term, the percentage is much greater.

Yet everywhere you go, investment advisors claim they’re generating superior results. It’s a bit confounding. So let’s take a closer look…

Why Money Managers Fail to Beat the Market

Most money managers fail to beat the market for a number of reasons.

Some, quite frankly, are inexperienced or inept.

Others, being human, make mistakes.

Some find it impossible to beat the market after charging substantial fees.

And most operate at a disadvantage because they must keep substantial cash on hand to meet redemptions. (And cash is a notoriously poor performer.)

Yet despite these headwinds, many money managers – perhaps most – still claim that they’re beating the market. Are they lying? You be the judge…

Beating the Market’s Isn’t Arithmetic… It’s Geometry…

I once attended a conference where the speaker – a local money manager – claimed that his managed accounts had averaged a 25-percent annual return over the previous two years, an impressive number during a difficult period.

But a member of the audience took issue with his claim. “I invested $200,000 with you two years ago,” he said. “And while you did double my money the first year, the account lost half its value the next. I’m now back to $200,000. So how can you claim a 25-percent annual return?”

Without missing a beat, the speaker wrote out the calculation on the overhead. He showed that when you subtract the 50-percent loss the second year from the 100-percent gain the first, you end up with a 50-percent return. And 50 percent divided by two years is a 25-percent average annual return.

This left many in the audience scratching their heads. He was correctly determining the arithmetic average, a meaningless calculation when negative numbers are involved. What all investors should be interested in – indeed what the SEC now requires funds and registered reps to provide in their literature – is the average annual geometric (or compounded) return. What the money manager was saying, strictly speaking, was true. But it was also meaningless and misleading.

Excluding Dividends and Outperforming the Wrong Benchmarks

Other managers boast of beating the market in a less audacious but still erroneous way: They understate the market’s performance by leaving out dividends.

For example, over the last decade, the S&P 500 has averaged just 0.7 percent annually without dividends. But with dividends it has returned 2.81 percent annually. That’s still no great shakes, but easier for brokers and money managers to beat.

How often is this done? It’s hard to say, but The Wall Street Journal reports that Allan Roth, a financial planner at Wealth Logic in Colorado Springs, estimates that at least 20 times a year he sees “account statements from financial advisors comparing a client’s returns, with dividends, against those of market benchmarks without dividends.”

There’s yet another way – an even simpler way – that money managers outperform their benchmark. They use the wrong one. Fixed-income managers will compare their performance to an equity index. Small-cap managers will compare their performance to a large-cap index. Global equity managers will compare their performance with a domestic index. And vice versa.

Major investment banks have one more trick up their sleeves. When a fund (or managed account) performs particularly poorly, they shut it down or merge it into another one. Poor returning funds? No problem. Just get rid of them.

Past Performance Doesn’t Predict Future Results

Let me state, for the record, that ethical money managers don’t do these things. However, not all firms are ethical. And not everyone at a first-rate firm is an ethical representative. I could tell you stories that would raise the hair on the back of your neck.

So what’s the takeaway here? First, if you’re paying for investment services, know whom you’re dealing with. Examine the printed literature and don’t rely on oral representations. Second, when a money manager states his average annual investment returns, recall the old boilerplate: Past performance really doesn’t predict future results.

And that past performance? You may want to look twice.

Good investing,

Alexander Green