A recent WSJ article hailed the return of good performance for stock pickers. The argument the article makes is that in recent years, stocks have mostly moved together for a variety of reasons, including strong signals from central banks. The strength of how stocks move together, or their correlation can easily be measured.
As the graphic shows, during the recent recession, correlation between stocks was fairly high, but the correlation has trended lower in recent months. Stock pickers argue that this is good for them, because when stocks are too strongly correlated it is hard for experts like themselves to differentiate themselves from a less advanced investor. The article closes with an ironic statement from a stock-picking fund manager. He states, “The sorting-out process has to return to fundamentals.”
The argument of stock-pickers makes a subtle but important observation: Performance is relative. Over spring break, a peer mentioned that his friend had given him a hot stock tip last year and made him some money. I had to break it to him that his friend was no savant, but the entire market performed exceptionally last year. This story illustrates the point stock pickers make; since the whole market was moving up, it didn’t take skills to do well, or even get lucky. Thus, doing well, compared to other investors, was difficult, because everyone did well. This observation is accurate so we cannot, and should not judge how good a fund manager is based the nominals returns he/she brought in, but the returns relative to the market. What does the evidence say about the performance of stock pickers, who are also known as “active” fund managers?
Unfortunately for stock-pickers this is where their confidence, some might call it arrogance, clashes with their results. The facts are simple: “historically, active managers have tended to perform badly, even when dispersion was above average”. Dispersion is another measure of how much stocks vary compared to one another, and has an inverse relationship to correlation. The very same feature of the market that stock-pickers were touting as beneficial for them has not helped them one bit! The author of the article advocates for investing in passive funds or indexes to save on transaction costs.
Looking at the evidence, I will admit that my view lies somewhere in between these two articles, similar to those of Burton Mankiel. The overwhelming statistical evidence is very convincing that trying to pick the right stocks (or stock manager) is nearly impossible. The silly arguments that active managers use while pointing at previous returns for their funds fall dead on the ears of managers who underperformed and are now looking for a job. However, success investors can make a lot of money, Warren Buffet being an example. As Burton Mankiel writes towards the end of his commentary on fundamental analysis in “Random Walk”, “if there are exceptional financial manager, they are very rare, and there is no way of telling in advance who they will be.” Speaking of the 30+% rise in the S&P500 in 2013, Mr. Buffett “warned shareholders in his last annual letter he would be unlikely to beat [those returns]”.
I think an interesting line of investigation from here is determining why the general public entrusts so much money to active investors, when the results show that may not be the best investing strategy. I suspect part of the reason is ignorance, that the general public doesn’t know what the statistics say or don’t understand the importance of relative gains. Perhaps another reason is fear; the stock market has a reputation of being a tough place, and some people will turn to a professional out of fear. Other reasons, like referrals, belief in stock -picking could also play a part in this trust, whether it is well founded or not.