The debate around whether active management adds value centres around the ability of managers to beat the market cap weighted indices such as the FTSE or the S&P 500.
However, Edwards and Lazzara say this gives a distorted impression of performance as it is using a flawed benchmark, and the average investor could beat the benchmark simply by picking stocks with a pin.
Active managers have landed some blows in recent years: the rising market of the past 24 months has seen most active funds outperform the trackers, which produced consistent bottom-quartile performance.
Performance of sector and index over 2yrs
Source: FE Analytics
However, this has reversed in 2014 as the large caps have come back into fashion and dragged up the returns of the indices they dominate.
Performance of sector and index in 2014
Source: FE Analytics
The temptation is to put down these periods of outperformance to active managers overweighting the small and mid cap areas of the market which traditionally outperform in the longer run and have had an exceptional period. However, Edwards and Lazzara say there is more going on.
Other ways it is possible to beat the index include buying cheap stocks – the value approach – buying less volatile stocks, buying high yielders and buying growth stocks. It almost seems harder not to make more money than the trackers.
In fact, research published last year by Cass Business School showed that if you had picked stocks at random you would have beaten the S&P 500 99.99 per cent of the time.
This apparently leads to the conclusion that the average monkey could beat the average manager – which suggests it might be possible for Trustnet readers too.
Edwards and Lazzara suggest that the reason why all these different strategies outperform is that they approach the performance of an equally weighted index of stocks, which has significantly outperformed the market-cap weighted indices over the past 20 years.
The expected return from picking stocks at random – the average return – is the return of the average stock – and this is the same as the expected return of an equally-weighted index.
This means when equally-weighted indices outperform, picking the average stock will also outperform. Picking stocks at random will also outperform – on average, of course, not every possible portfolio.
The analysts suggest that the equally-weighted index is a superior benchmark than the standard market-cap weighted indices, given that it represents the results of a random selection.
In this light, it is even more worrying that the average manager is unable to outperform, since it appears to be literally the case that monkeys are better at picking stocks.
The analysts’ first point is one that has been made before: not that many funds are that active.
Many managers stick close to their benchmark thanks to their mandate, concerns about losing their job if they take big bets and lose, and short-term goals and incentives.
Managers who don’t deviate far from their benchmark will find their results dominated by their fees, as the evidence suggests it is.
Source: S&P Dow Jones Indices
Research by Antti Petajisto suggests that those fund managers that take on the greatest active share do indeed outperform their market cap weighted benchmarks.
Those that can be classed as “stock-pickers” return on average 1.26 per cent more than their benchmark, according to Petajisto’s research.
Edwards and Lazzara’s research suggests an explanation for this that is perhaps less favourable than the managers would like: high active share outperforms because it is closer to the result of the equally weighted portfolio.
In other words stock-pickers outperform when the average stock outperforms. In this light, using market cap weighted indices as benchmarks for active managers might be making it too easy for them.
It should theoretically be possible for the average investor to outperform the FTSE and active managers by picking stocks at random.
