Stock-picking doesn’t work, studies on fund performance show.
You’ll succeed in investing if you do your research first.
By Daniel Solin
Few can forget the iconic phrase in the movie “Jerry Maguire,” when Tom Cruise says, “Show me the money!” Here’s a similar mantra that will change the way you invest: “Show me the evidence!”
A cursory review of what passes for “financial advice” demonstrates the importance of following this mantra. Here’s a sampling:
Pimco’s advice. Virginie Maisonneuve, deputy chief investment officer and global head of equities at Pimco, recently provided her views on the long-term outlook for the stock markets. Among the “key takeaways” was her advice that in order to get “alpha,” investors should focus on growth areas that will benefit from solid fundamentals. These “growth areas” include regions, sectors and companies. Ms. Maisonneuve also advised investors to “focus on super-secular trends that will be drivers of growth or change over the long-term horizon.” Candidly, I am not certain what that means, but I believe Maisonneuve is advising investors to engage in trying to pick sectors and stocks that will outperform the market.
The evidence: At best, stock-picking is an elusive (if not nonexistent) expertise. A 2010 study called “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” by Laurent Barras, Olivier Scaillet and Russ Wermers analyzed the performance of 2,076 mutual fund managers over a 32-year period. It could not find evidence of stock-picking expertise in 99.4 percent of these managers. If this is the track record of professional fund managers, how do you like your chances?
Trying to pick a sector that is likely to outperform is also very risky business. According to Morningstar, the volatility of the average technology fund (as measured by standard deviation) is almost twice the level of the Standard & Poor’s 500 index.
The sheer number of sector funds available (which span eight different Morningstar categories) make the odds of picking a “winner” daunting. By investing in a broadly diversified stock fund (like the Vanguard Total Stock Market Index Fund), you would have exposure to most major U.S. industries. Why should you speculate with a sector fund?
Learning from Dr. Andrew Lo: It would be difficult to find someone with more impressive credentials than Andrew Lo. He has a bachelor’s degree in economics from Yale University and holds a doctorate in economics from Harvard University. He is a professor of finance and director of the laboratory for financial engineering at the MIT Sloan School of Management. He has published many impressive articles on finance in peer-reviewed journals and is the recipient of numerous awards for his scholarship.
The evidence: According to a Business Insider article by Joshua Brown, an investment advisor, Dr. Lo is the principal in a fund called ASG Diversifying Strategies Fund. The fund uses many different approaches in the management of its assets, including derivatives and diverse “trading methodologies.” According to Brown, since its inception in August 2009, the fund lost money in both good and bad years. Brown computes its compounding loss to be around a decrease of 7 percent a year since 2010. In 2010, a banner year for the market, it was up 8 percent. The S&P 500 index returned 15 percent. In the year to date, it’s showing a negative return of 0.73 percent, even though almost all asset classes are showing positive returns.
Investors in this fund are paying dearly for this dismal performance. Mr. Brown computes its net internal expense ratio as being close to 2 percent of assets. Brokers who sold the A shares of this fund were paid 5.75 percent upon purchase.
Do you believe you are smarter than Dr. Lo?
The Dennis Gartman story: Dennis Gartman is the editor and publisher of The Gartman Letter. He is a frequent contributor on CNBC and Bloomberg TV, where he dispenses opinions about the direction of the markets and the future price of various commodities. He has been publishing his investment newsletter since 1987. Clients of his newsletter include many of the leading banks, mutual funds, hedge funds, energy trading companies and grain trading companies, to name a few. I assume these and other subscribers find his views of value.
The evidence: In an article published in The Wall Street Journal last week, Gartman admits his predictions about an imminent stock market correction were “wrong … badly.” He described himself as “going from nicely bullish to neutral sometimes and every time I turn neutral I wish that I hadn’t.” He conceded that it was “silly” for him to think that he could call a correction. He concluded that “the market will correct when it corrects. That’s what I’ve learned in my 40 years in the business.”
The track record of The Gartman Letter is probably no better or worse than other investment newsletters. A seminal study, “The Performance of Investment Newsletters,” published in October 1998 analyzed the performance of all investment newsletters tracked by the Hulbert Financial Digest. The study found an “inability of newsletters to beat market averages.”
The takeaway: You may be surprised when you ask your broker to justify his or her recommendations with peer-reviewed evidence. After getting over the shock that anyone would question his or her judgment, the answer most likely will be, “There is none.”
If this happens to you, consider the sage advice of William Bernstein, one of the most prominent financial theorists of our time. Bernstein just published a gem of an e-book, “If You Can: How Millennials Can Get Rich Slowly.” He counsels millennials to avoid all stockbrokers, all full-service brokerage firms, all newsletters, all advisors who purchase individual securities and all hedge funds.
Bernstein offers sound, evidence-based advice on investing. It is applicable to all investors. The 99 cents you’ll spend on his book may well be the best investment you will ever make.
This post originally appeared on US News Money on June 4th, 2014.