Do Investment Managers Beat The S&P Performance?

Beating the market is a challenging feat, and few can claim to have achieved it. The S&P 500, a benchmark of overall US stock market performance, is the standard against which investment managers measure their success. However, data shows that the majority of investment managers fail to outperform this index consistently. In fact, only 15% of US funds beat the S&P 500 over the last decade, and even fewer can do it regularly. This raises the question: is it luck or skill that drives the small number of managers who do beat the market?

The difficulty of beating the market

Beating the market is notoriously difficult. The S&P 500's high returns, for example, have been immensely challenging to beat over the past decade, with only 15% of US funds in the IA North America sector with a 10-year track record outperforming the index.

In fact, since 2001, there have only been three years in which a majority of active funds beat the S&P 500 index: 2005, 2007, and 2009. This highlights the difficulty of beating the market and underscores the importance of researching before investing in an actively-managed fund.

There are several barriers to beating the market. One significant obstacle is investment fees. When investing in an S&P 500 index fund, the fund's performance should match the S&P 500's performance, but after subtracting investment fees, it becomes challenging to beat the market. Taxes also present a substantial hurdle, as paying tax on investment returns can result in a significant loss of profit.

Investor psychology can also hinder efforts to beat the market. Many people tend to buy when the market is performing well and sell out of fear when it starts to drop, leading to buying high and selling low. While it is possible to take on more risk to outperform the market, this strategy can also bring greater losses.

Superior analytical skills and information can also play a role in beating the market. However, it is challenging for individual investors to possess superior information without engaging in illegal insider trading. Even well-known investors like Peter Lynch and Warren Buffett, who picked individual stocks, may have been exceptionally lucky despite their financial prowess.

In summary, beating the market is a challenging endeavour due to various factors, including investment fees, taxes, investor psychology, and the difficulty of obtaining superior information. While it is possible to take on more risk to outperform the market, this strategy is not without its pitfalls, and luck often plays a significant role in investment success.

Active funds vs. passive funds

The biggest difference between active and passive investing is that active investing involves a fund manager picking and choosing investments, whereas passive investing tracks a group of investments called an index. Passive investing strategies tend to perform better and are cheaper.

Active funds

Actively managed funds are managed by professional fund managers who buy and sell securities based on their expectations for how those securities will perform. Active funds can potentially generate market-beating returns. Active funds are more flexible than passive funds, and they can be used for hedging and risk management. They also allow for tax management strategies tailored to the individual investor.

However, active funds tend to be more expensive than passive funds because they require extensive research and analysis. Actively managed assets can play an important role in a diverse portfolio, but even large investors often do best using passive investments for the bulk of their holdings.

Passive funds

Passively managed funds are designed to mirror the performance of an index by holding the same or similar securities in the same proportions. Passive funds tend to deliver more consistent returns with lower fees. Passive funds are also more tax-efficient because their buy-and-hold style does not trigger large annual capital gains tax.

Passive investing tends to be the winner for most investors. It is quicker and easier and delivers better overall returns. Passive funds also allow investors to stay passive and hold their positions, which is a more realistic approach for most investors.

However, there is no right or wrong answer when it comes to choosing between active and passive funds. It depends on the investor's goals, time horizon, and other factors.

The role of investment advisers

A good investment adviser will not promise to "beat the market", as this is unlikely to happen. In fact, data from the S&P Dow Jones Indices shows that 60% of large-cap equity fund managers underperformed the S&P 500 in 2020, and in most years since 2001, a majority of active funds have failed to beat the index. Rather than trying to beat the market, a good adviser will focus on helping their clients make informed investment decisions that align with their financial goals and risk tolerance.

That being said, there are some instances where investment advisers may be able to outperform the market. This could be due to superior information or analytical skills, or simply luck. For example, in 2022, nearly 70% of actively managed US stock mutual funds with the goal of beating the S&P 500 Index had done so by May. However, this was an unusually high number, and it is unlikely that these advisers will be able to consistently outperform the market over the long term.

Ultimately, the decision to hire an investment adviser depends on an individual's financial goals, risk tolerance, and personal preferences. While some people may prefer the personalised advice and guidance that an adviser can provide, others may find that a DIY approach using investment apps or algorithms is more cost-effective and convenient.

Barriers to beating the market

Beating the market is a challenging feat, and only a small percentage of investors consistently achieve this goal. Various barriers stand in the way of surpassing the market's performance, and understanding these obstacles is crucial for informed decision-making. Here are some key barriers to beating the market:

Investment Fees

Investment fees present a significant hurdle for investors aiming to beat the market. When individuals opt for investment funds, their returns are diminished by the fees charged by these funds. While investing in an S&P 500 index fund can match the market performance before fees, it is challenging to surpass it due to the fees subtracted from the returns. Even in the case of index funds with ultra-low fees, equalling the market performance is more realistic than outperforming it.

Taxes

Taxes are another substantial obstacle to beating the market. Capital gains tax, ranging from 15% to 20%, reduces an investor's profits significantly. This tax rate applies to investments held for at least a year, while stocks held for shorter periods are taxed as ordinary income, further impacting returns.

Investor Psychology

The behaviour and emotions of investors themselves can also hinder their ability to beat the market. A common tendency is to buy when the market is performing well and sell out of fear when it starts to decline, resulting in buying high and selling low. Overcoming this psychological barrier requires diligent research and analysis, enabling investors to make more informed decisions based on a company's potential for future gains rather than short-term market fluctuations.

The Disposition Effect

The disposition effect refers to the common behaviour of investors, both retail and mutual fund managers, who tend to cut their losses and let their winners run. However, research indicates that this strategy costs investors approximately 5-6% in annual returns. Instead of holding onto losing investments in hopes of a turnaround, investors would be better off selling their winning investments, which often continue to appreciate in value.

Overconcentration and Overleverage

Retail investors often overconcentrate their investments in specific sectors, particularly those with high volatility, such as automakers, travel stocks, and technology. This strategy leaves them vulnerable to significant losses during market downturns. Additionally, the use of margin, overtrading, and excessive use of call and put options can amplify risks and negatively impact returns.

While beating the market is challenging, it is not impossible. However, it requires a combination of business acumen, diligent research, emotional discipline, and sometimes, a bit of luck.

Luck vs. skill in stock picking

Stock picking is a challenging endeavour, and the majority of active funds fail to beat the S&P 500 index. This has been the case for almost every year since 2001, with only three exceptions: 2005, 2007, and 2009. The exceptional performance of stock pickers in these years can be attributed to unique market conditions, such as the high volatility following the 2008 financial crisis, which provided skilled fund managers with opportunities to identify undervalued stocks.

The difficulty in outperforming the S&P 500 is evident when examining the performance of investment advisers. Data shows that in 2020, 60% of large-cap equity fund managers underperformed the S&P 500, marking the 11th consecutive year that the majority of fund managers failed to beat the market. This trend is not limited to a single year, as a study by S&P Dow Jones Indices found that not a single mutual fund consistently and convincingly outperformed its benchmark in the US stock or bond markets over a five-year period.

However, it is essential to acknowledge that some investors have achieved remarkable success through stock picking. Household names like Peter Lynch and Warren Buffett have attributed their success to their investing style, timing, and analytical skills. Warren Buffett even placed a famous bet in 2008, wagering that an S&P index fund would outperform a hedge fund portfolio consisting of actively selected stocks over ten years. Buffett won the bet, with his index fund generating a 7.1% annual return compared to the hedge fund's 2.2%.

So, is it luck or skill that determines success in stock picking? The answer may lie in a combination of both factors. While individuals like Lynch and Buffett possess exceptional financial acumen, even they may have benefited from a certain degree of luck. Economists have demonstrated that a portfolio of randomly chosen stocks can sometimes perform as well as one that has been carefully curated. Additionally, various factors work against investors aiming to beat the market, such as investment fees, taxes, and investor psychology, which can lead to suboptimal buying and selling decisions.

Ultimately, while it is possible to beat the market through stock picking, it is a challenging endeavour, and most investors are unlikely to consistently outperform the S&P 500. As such, many experts recommend a passive investment approach, utilizing low-cost index funds that mirror the overall market performance, rather than attempting to time the market or pick individual stocks.

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