What Everyone Really Needs to Know About Investment Management


Last year was a pretty solid one for stocks. The S&P 500 was up 16% in 2012, which was far better than many experts had been forecasting.

Sadly, it was another bad year for investment managers. According to Goldman Sachs, 65% of U.S. large-cap core stock funds underperformed the S&P 500 in 2012 after fees. And hedge fund managers did even worse -- an alarming 88% of them underperformed the index last year.

Unfortunately, 2012 didn't represent an isolated instance of underperformance by active fund managers. In 2011, a staggering 84% of active U.S. stock funds underperformed the S&P 500. Over the past 10 years through 2011, the average percentage of mutual funds underperforming the market has been around 57%. As for hedge funds,The Economistreports that the S&P 500 has outperformed the relevant hedge fund index for "ten straight years, with the exception of 2008 when both fell sharply."

What should investors make of this woeful investment performance on the part of active managers? Is it time to abandon actively managed funds for individual stocks, index funds, and ETFs? Before addressing those questions, let's take a closer look at the numbers.

It's worse than you think
In early 2012, S&P Dow Jones Indices (link opens PDF file) published a report with some worrying data about active mutual fund performance. In addition to the troubling stats above, 56% of funds underperformed from 2009 through 2011, and 61% of funds underperformed over the past five years.

The report notes that the only consistent data point "over a five-year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices."

Hedge fund managers have delivered equally unimpressive results over the past decade. The Economist notes that these market wizards as a group have delivered returns that are lower than inflation over the past 10 years.

Making sense of it all
"Yeah, but the data is only about averages," you might be thinking. Just because mutual funds and hedge funds underperform on average over long periods of time doesn't mean that some outstanding managers can't consistently beat the market over the long term.

I think that's a legitimate point. So the key question for me, after looking at the data, is this: Do ordinary investors and financial advisors have the ability to select those investment managers that can consistently perform better than the average?

I'll resist the urge to provide a sweeping answer to that question. Each individual must ultimately determine for themselves if they possess the capability to identify top-performing investment managers.

I will, however, share my own thoughts on this tricky topic.

No, maybe...
If I was trying to determine if a particular fund could outperform its relevant benchmark, I'd want to know a few things. First, I'd look at the easy stuff. As a long-term investor, I'd want to know that the fund's fees weren't too high, and that it didn't trade too much. I'd also want to make sure that it was truly an active fund, and that it wasn't just shadowing its benchmark.

Most important, I'd want to know quite a bit about the managers of the fund. What is their process for picking stocks and managing risk? What does their education and experience consist of? Have they outperformed the market in the past? What's their temperament like?

Those questions are much harder to get meaningful answers to than one might think. And it isn't always easy to learn enough about an investment manager's process and temperament without actually interviewing him or her in person.

So my highly nuanced view is that, given enough quality information, I might be able to select a manager who will outperform in the future. For most funds, however, it's very unlikely that I'd have enough information to make a good decision. In those cases, then, I'd say I wouldn't be able to select an outperforming investment manager. That's why I pick my own stocks and pretty much avoid mutual funds altogether.

I may not be the only one
It appears that I may not be the only investor out there who isn't confident they can identify the relatively few outperforming investment managers. Vanguard, which specializes in passive index funds and ETFs, announced recently that it set a record last year for inflows of new cash. As a whole, the U.S. ETF industry attracted record net inflows of $187.2 billion in 2012, while active mutual funds actually saw withdrawals of a record $152 billion.

This is a very positive development, in my opinion. We've grown so accustomed to financial horror stories that it's extremely hard to believe that good things happen too sometimes. In this case, more and more investors are choosing low-cost solutions instead of relatively expensive funds that underperform on average. Maybe we're all getting wiser, after all.

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The article What Everyone Really Needs to Know About Investment Management originally appeared on Fool.com.

John Reeves has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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