How the bears beat the bulls

Investors want active fund managers who beat the equity markets. Managers who underperform in the short-term can be forgiven if they outperform in the long-term, for example over a decade.

Over the 10 years to October 2011, less than 7 per cent of global large cap managers beat the MSCI World Equity Index. For equity investors, those 10 years were a dismal period indeed: world equities returned 4.5 per cent a year including dividends before tax, and inflation was up 2.5 per cent per year, leaving 2 per cent after inflation for the investor.

The vast majority of active equity managers didn’t make that much. If we take a slightly longer timeframe such as the 12 years up to the end of 2011, investor returns are even worse: world equity markets gave almost no return, about 0.25 per cent per year including dividends before tax, which meant investors lost -2.5 per cent per year after inflation.

Investors want to do better. With two major equity bear markets and two major equity bull markets appearing over the past 12 years, there are strong arguments in favour of hiring active fund managers for global large capitalisation stocks, but the very small number of active managers who beat the index means that it is not an easy task to find them.

When markets go through bubbles and financial crises, the boom and bust cycles generate high volatility. The golden few active managers who rewarded their investors by beating the market essentially did so by sheltering assets during the crashes and putting them back to work during the rebounds.

That is the geometry of investing: if you lose 50 per cent you must increase by 100 per cent to get whole again. Because market gyrations were extreme over the period, most of the rare successful managers had a conservative-active approach that kept their overall returns steadier than the market and enabled them to do better long-term.

The lessons of the past decade are becoming clear for many investors. Inexpensive and reliable tracker funds are certainly worth considering for a sizable share of portfolio holdings if they do as well as or better than 93 out of 100 active funds for global, large capitalisation stocks.

Active fund managers who do beat the market most likely will have an investment process attuned to getting out of the way of market crashes, something that will show in track records that have steadier, less volatile returns than the market. Also, investors should keep a lookout to spot active managers such as these: given that only 7 out of 100 make the cut, they are worth their weight in gold.

John Ricciardi is head of investments at Kestrel Investment Partners. The views expressed here are his own.