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Capitalistic greed the downfall of fund performance

They say there is relatively little to no academic research that shows active managers have true stock-picking skill. That's partly the reason for the explosion of index funds. But according to one study, 80 per cent of fund managers actually do have skill. The problem though, is that we are all capitalist pigs so it doesn't matter.

You know those disclaimers at the bottom of every investment fund ad that says "Past performance may not be repeated?" They are required because decades of research indicates that, as you might surmise, past performance has pretty much nothing to do with future performance.

It's clearly possible to beat the market, it's just very hard to predict who will do it in the future. More than one study indicates that outperformance by a fund manager might be due to nothing more than skill.

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So isn't it puzzling that many of these ads feature a graph or chart specifically detailing the past performance as the main selling feature? Apparently not.

Richard C. Green and Jonathan Berk released findings in 2002 which essentially proposed that most managers have skill to at least earn back their fees. Unfortunately, when investors identify outperformance they give these managers more and more money, up to a point that they can no longer deploy it effectively.

Think of it this way. If you had a small-cap fund with only $50-million of assets, a manager would ideally put all $50-million into their best idea. Securities regulations require that they not put more than 10 per cent of a fund's assets into any one company, nor can they own more than 10 per cent of a company (without applying for exemptions). So perhaps they hold 10 different companies, representing their best 10 ideas. Imagine that this fund shoots the lights out for a few years. People would notice and money would start flowing into this fund. Now the manager might have to find 100 good ideas. Their hundredth idea is less likely to do as well as their first idea.

The authors reason that this may be part of the reason past performance translates poorly to future results.

Bloody capitalists.



Preet Banerjee, B.Sc, FMA, DMS, FCSI is a W Network Money Expert, and blogs at wheredoesallmymoneygo.com. You can also follow him on twitter at @PreetBanerjee

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About the Author
Personal Finance columnist

Preet Banerjee is a consultant to the financial services industry. You can follow him on twitter at  @PreetBanerjee. You can find his conflict of interest disclosure on his website. More

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