What does the data tell us about how to invest successfully? If you scour the world of peer reviewed academic studies over the last few decades (don’t worry you don’t have to because we and many others have) you’ll learn that the evidence clearly points to keeping costs low and keeping holdings very diversified. Unfortunately for those fund managers that try to perform better than market benchmarks by picking better securities or timing market swings, the data shows clearly it’s not worth paying their fees to do so. Statistical Ideas kindly aggregated the latest S&P Indices data showing the performance of the average active fund manager across a variety of countries and asset classes over ten years versus simple market benchmarks.
Not good. And don’t think you can overcome this by finding that better than average manager. The evidence also suggest it’s nearly impossible to identify outperforming managers in advance. In fact a large portion of funds don’t even survive a ten year period, let alone outperform.
So is the only choice to move all of your investments into low cost index funds based on simple market benchmarks? Not necessarily – the ETFs and index mutual funds that track simple market benchmarks are low-cost and should outperform active funds after fees, but the evidence also shows it’s possible to do better. There’s been a lot of hype around “smart beta” or “enhanced indexing” recently. The idea is that rather than choosing market benchmarks that use a simple market capitalization to weight their index constituents, there are other “factors” that if used to weight the index will yield a superior return. Smaller companies, cheaper companies, more profitable companies, stocks with more price momentum or less volatility are all examples of characteristics or “factors” that have been tested by the academic community and shown to yield higher investment returns. You would think that by now and given how well publicized some of these anomalies are that the market would have caught on and bid up their price to the point where they no longer offered superior returns. An interesting research paper highlighted in this recent article from Alpha Architect takes a look at how some of these factors performed after being revealed to the world by academic studies.
The bottom line is that these anomalies do exist and have persisted and therefore it has been possible to continue to exploit them by using a superior low-cost indexing strategy over a simple market capitalization weighted index. But of course there is no free lunch and there are catches:
- The higher returns come with more risk
- The strength of the factors seems to have lessened somewhat since first revealed
- You need a long term horizon – it can be painful if you have a short term focus on beating standard market benchmarks
- It requires a very sophisticated approach and most “smart beta” efforts don’t measure up
If you can overcome the above, it’s possible to outperform basic market benchmarks.