Money Madness

Posted by Myles B Brandt on 6 April 2010 | 0 Comments

Tags: Investment, Passive, Benchmark

Similar to many of you, I watched with amazement as Northern Iowa beat Kansas in the men's NCAA basketball tournament. Kansas was favored to win the entire tournament. The last time Northern Iowa made it past the second round was in 1990. Farther east, 12th seeded Cornell upset 4th seeded Wisconsin to move onto the Sweet 16. Cornell had yet to win a tournament game before this year. As of March 19th, there were 4.8 million brackets submitted to ESPN. After the first day of the tournament, only 56 were correct. There were so many upsets that only .001% of participants were correct. And that was just after the first day.

After the second day, there were no brackets completely correct. Most brackets, on average, have missed 10 games. This is called a survival rate and this year, nobody survived.

A very similar thing happens in the world of investments as investors compete with each other for returns. Every year some funds beat their respective benchmark. These are the survivors. The next year, some of the survivors will beat their respective benchmarks again and move on in the bracket. But what is the survival rate and what are the implications of the survival rate? Consider the chart below.

This graph shows the percentage of actively managed funds that beat their benchmark in consecutive years. In 2004, 33% of funds beat their benchmark. By 2008 only 1.4% of all funds had beaten their benchmark every year. Although the survival rate for actively managed equity funds is higher than this year's NCAA tournament, the implications are huge.

Many people believe that as a group active managers can add value. In order to do so, one has to choose winners in advance. Often they chose managers with strong past performance, much like 42% of people that had Kansas winning the entire tournament. However, the evidence suggest that this is extremely hard and may have more to do with luck than skill.

For bond funds, it's the same story. After 5 years, by 2008, only .5% of all actively managed bond funds beat their respective benchmarks. That's 7 out of 1,670.

So the implications for the investor are simple. You have two choices. You can simply invest in the benchmark and after 5 years have beaten 98.6% of all other funds, or you can take your chances at beating those benchmarks. Your chances of winning are, of course, slim to none. Your chances of losing are high to inevitable.