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STANDUP Advice: Reliably Identified in Advance

John J. De Goey, CFP
0 Comments|September 7, 2007

Ouija boards have a better chance than the average fund manager of outperforming the market
Ouija boards have a better chance than the average fund manager of outperforming the market

Superior security selection requires two things:

i) the ability of managers to select securities that will, in aggregate, outperform their benchmark (net of fees)

ii) the ability of others to reliably identify those managers in advance

Getting the first without the second is of no value if the majority of managers cannot be reliably identified in advance. Getting the second without the first is impossible because, by definition, if the first event does not happen, the second event cannot happen. Let's take a quick stroll down the trail of money manager logic to think this through.

There are people out there who claim to be able to do each of those two things. Mutual fund managers and stock picking brokers make up the lion's share of the first group; conventional advisors, members of the media and self-appointed gurus make up most of the second. Ironically, this leads us to a circular problem that makes the pursuit impossible. If superior managers both existed and could be reliably identified in advance, then everyone would give all their money to these superior managers. The entire exercise would collapse like a house of cards. Here's why:

Let's assume there are 1,000 mutual funds in a given market. Let's further assume that only 10% (a charitable assumption) will end up with a 20-year track record that surpasses the benchmark. For the record, that's about the long-term percentage of funds that beat their benchmark over that timeframe, after taking tracking error, survivorship bias and other factors into account. If the 10% superior managers could indeed have been reliably identified in advance, wouldn't everyone have given all their money to that subset of the larger sample?

Imagine if you were allowed to bet on horse races after the race was over. It'd be pretty easy to win, wouldn't it? What kind of idiot would still bet on the wrong horse? And why are there so many fourth quartile managers with millions (sometimes billions) of dollars in assets under management if superior managers can be reliably identified in advance? There are lots of advisors and media types who suggest that picking winners is a reliable undertaking. Evidence suggests otherwise. If the managers that outperformed could have indeed been reliably identified in advance, then the people who gave their money to those the managers who lagged would be complete idiots.

There's no other explanation, unless, of course, the 10% that outperformed could not have been identified in advance. And if that is the case, then we have to stop believing that there are gurus out there who can do this. Let's look at this the other way. What if the outperformers could be identified and every investor gave all of their money to one of the 10% outperformers? The other 90% would be out of business pretty much immediately. In actual fact, the reality would be even more extreme. If winners could be reliably identified in advance, no one would give one thin dime to the (would be) laggards in the first place!

Either way, if the laggards were out of business, then the 10% outperformers would collectively constitute the entire market - if one used the simple assumption that all active managers were a good proxy for the total market. It should go without saying that it is impossible to collectively beat the market (the top 10%) when in fact you are the market (i.e. the only money managers still in business). You could repeat the exercise, I suppose, and have ten money managers that outperform the other 90 in the universe of 100 surviving (previous) outperformers, but again, if they could be reliably identified in advance, why would anyone in their right mind give one thin dime to one of those 90 when there are ten reliable outperformers just waiting to "add alpha" for you?

Repeat the process one more time and you eliminate the nine value-subtracting managers from the remaining universe and you'll be left with one measly fund- also known as "the market." At that point, alpha would have disappeared. That's the thing about market efficiency. If there were actual inefficiencies, they would be exploited out of existence.

John J. De Goey, CFP is a Senior Financial Advisor with Burgeonvest Securities Limited (BSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BSL.

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