Cameron Passmore CIM, FMA, FCSI

Portfolio Manager

Benjamin Felix MBA, CFA, CFP

Associate Portfolio Manager
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Why Is It So Hard To Beat the Market? part II

In my last video, I talked about some of the challenges that active managers face in outperforming the market. It boils down to their relatively high fees, and intense competition from other managers.

There is another, less obvious reason that active managers have so much trouble beating the market. We know empirically that a small number of stocks in an index tend to drive the performance of that index. So trying to select stocks in an index dramatically increases the probability of underperforming. When trying to pick stocks in an index in an effort to beat the index, the likelihood of underperforming is much greater than the likelihood of outperforming.


If we look at data on market returns, the basis of this research is clear. Most of the market’s returns come from a small number of stocks. Let’s look at an example using data from global stock markets between 1994 and 2016.

Over that time period, global stocks returned an average of 7.3% per year. Not bad at all. If we remove the top 10% of stocks in that global market portfolio, the average annual return drops to 2.9%. Excluding the top 25% results in the average annual return dropping to a much less exciting -5.2%. Of course it would be great if active managers could identify only the top performing stocks, but we have seen the data around their ability to do so - it doesn’t look good.

We know that, in most cases, active managers’ performance can be attributed to luck rather than skill. A lucky manager has been fortunate to randomly select stocks that have done well. In their paper, Heaton, Polson, and Witte lay out a very simple example explaining the challenge that active managers face based on what we know about market returns.

If we have an index consisting of five stocks, and assume that four of them will return 10% and one will return 50% over a given time period, and we suppose that active managers will create portfolios using an equally weighted subset of either one or two of those stocks, there will be a set of fifteen possible actively managed portfolios. Ten of the fifteen portfolios will earn a 10% return due to omitting the 50% stock, and five of the fifteen portfolios will earn either a 30% return or a 50% return due to holding the 50% stock, depending on whether it is a one or two stock portfolio. In this example, the average return of the stocks in the index, and all active fund managers, will be 18% (before fees).

Just like we would expect, all active managers together get the return of the market. But when we look at each portfolio individually, two-thirds of the actively managed portfolios will underperform the index due to their not holding the 50% returning stock, which is always included in the index.

Closet indexing is the result of active managers owning the market like an index fund, but charging active management level fees. Some active managers will pitch themselves as having high conviction, or high active share, meaning that they are very different from the index. The implications of this research are that even if you are able to find an active manager that is truly active and has low fees, there is a relatively low probability that they will be able to deliver market beating performance. With this high probability of underperformance, finding a skilled manager, which we already know to be beyond challenging, becomes increasingly important.

Fees typically take the blame for the systematic underperformance of active managers, but this research demonstrates another big hurdle that needs to be overcome to beat the market. If active managers miss out on the relatively small proportion of top performing stocks, they are at significant risk of trailing the market.

In my next video, I will be talking about downside protection, one of the most prolific sales pitches in the investment management industry. Do index funds protect your downside? Join me to find out.

My name is Ben Felix of PWL Capital and this is Common Sense Investing. I’ll be talking about this and many other common sense investing topics in this series, so subscribe and click the bell for updates. I’d also love to hear from you as to what topics you’d like me to cover.

By: Ben Felix | 0 comments

Why Is It So Hard To Beat the Market?

The data is in and, for fund managers who are still trying to “beat” the market, the numbers are still not on their side. As talented as active players often are at slicing and dicing the data, and as mightily as they may try, there’s considerable evidence that passive players continue to have the last laugh. Why is that? As usual, it has a lot to do with common sense.


It begins with simple math. Canada’s particularly high fund fees (on average) tend to add up fast. The challenge is further muddied by a tendency for investors to mistake lucky winning streaks as reliable results. Finding managers who have outperformed their highly competitive peers in the past – and will continue to do so moving forward – is far closer to a gamble than a guarantee.

Bottom line, after costs, it’s incredibly difficult to out-smart highly efficient capital markets that represent the collective wisdom of all market players, of all stripes. There are additional compelling reasons this is so. For example, have you ever heard the term “closet indexer”? To find out what that is, subscribe to Common Sense Investing and stay tuned for my next post.

By: Ben Felix | 0 comments

Why Aren’t More Canadians Switching to Index Funds?

First, the good news: At the end of 2016, 11.3% of Canadians’ investment fund assets were held in index funds and similar passively managed products. That’s a start. But compared to our U.S. neighbors at 34% of the same, we’re slow on moving away from over-priced, underperforming actively managed funds and into index funds.


Why are we lagging behind? In large part, I believe it’s because your banker or commission-based advisor is often failing to recommend the solutions that are in your best interests. Their complex compensation models aren’t encouraging them to sit on the same side of the table as you. And regulators aren’t sufficiently requiring them to do so.

 For indexing to become the same movement here that it’s become in the U.S., we’ve got to talk about simple fees versus complex commissions. We need to differentiate fiduciary from merely suitable advice. We need to continue promoting clear versus confusing cost disclosures. 

Most of all, we need people like you and me to recognize there’s a better way, and insist that we get it. Common sense? You bet. To join our movement, check out today’s video, subscribe to Common Sense Investing, and send me your own questions to address.

By: Ben Felix | 2 comments