It is well known that investing in equities is more profitable than bonds or cash over the long term. While one might assume this outperformance is achieved through active management – shrewd trading of individual stocks – the reality is this can be achieved through passive management – simply maintaining a portfolio equivalent to a broad equity index. Indeed, the S&P/TSX Composite Index attained a 10% compound annual return during the 10 years ended March 31, 2013, while the median Canadian Equity Fund returned 8.1%. Over 20 years, the index gained 9.7%, compared with 7.6% for the median fund.
However, a passive approach is difficult to accept for those investors who know the free-market system offers the opportunity for theoretically unlimited profit. This entices investors to play the market, strategizing when to buy and sell individual securities. The concept seems simple enough: Look for stocks that are undervalued, buy them and eventually sell them when they become over-valued. While some investors are able to beat the market, very few are able to do it consistently and even more lose money.
Why is this so? The answer is simple: markets work. A market is “efficient” if prices adjust quickly on average and without bias to new information. Thus current prices reflect all available information at any given point in time. A stock’s price may be based on hard information, but price movements will be random and unpredictable because new information inherently is unpredictable.
Furthermore, research shows fewer professional investors have been able outperform the stock market than even pure luck would suggest. While some active equity mutual fund managers have been able to beat the market, their ability to pick winning stocks is no easy feat. A further handicap is the fact that fees for actively managed funds are higher than for passive portfolios. Analysis by Standard & Poor’s and Eugene Fama at the University of Chicago shows that only 3% of funds have outperformed the market over the long term. Even though top performing portfolio managers – that 3% – may have achieved extraordinary rates of return in previous years, Fama contends that, after costs, they can only be expected to be as good as a low-cost passive index fund, while everyone else will do worse.
Even if you believe you have picked a fund that will outperform, it’s impossible to know for sure. A recent study by Vanguard Group showed that someone who chooses an active fund manager based on a successful track record has more chance of picking a loser than a winner.
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