Why Beating the Market Is An Uphill Skate
It is absolutely possible to beat the market, just as I’m sure it’s possible that someone could climb Mt. Everest in a pair of roller skates. It is so improbable, however, that it’s rendered a fruitless, if not counterproductive, pursuit.
After 16 years in the financial industry and seeing countless great investors eventually humbled by market forces they could not control, I’ve finally relinquished my skates.
Know Your Greek
First, we must define what it means to actually “beat the market.” We’re not talking about simply outperforming one of the major stock or bond market indices, like the S&P 500 or the Barclays BCS +1.38% U.S. Aggregate Bond.
Investors who take more risk than these benchmarks in years when taking risk is rewarded could—even should—have a higher expected rate of return. But doing so does not equate to a feat of investing brilliance. No, in order to claim dominance over the market, an investor must achieve a higher risk-adjusted rate of return—the prized, yet elusive, alpha.
Beta, in investing parlance, is the market. The market equals the number one. An investment with a beta of 1.5 is taking on more risk than the market and should enjoy a proportionately higher reward when the market has an upward trajectory, but you should also expect to lose more on the downside. An investment with a beta of less than one should respond to market stimuli with less gusto, or volatility, than the market.
Beta is all around us, but alpha is more like a shrouded ghost investors occasionally glimpse, but rarely capture. When the alpha ghost is captured, it does what those of us who regularly interact with ghosts already know—it slips through our grasp.
Depending on the year, you’ll find statistics confirming that the majority of actively managed funds—mutual funds and hedge funds, whose very existence is justified only by clinging to the hope of attaining alpha—underperform appropriate benchmarks. In any given year, 50% to 90% fail to beat the market.
An even more colossal failing is shown in active managers’ ability to beat the market over an extended period of time, or even a few years consecutively. A Vanguard study, which confirmed previous research, found that only 18% of active managers were able to outperform their benchmark over the 15-year period from 1998 through 2012.
Fully 97% of them underperformed in at least five of those years and “two-thirds of them experienced at least three consecutive years of underperformance during that span.”
Ivy League Investing
It’s always been hard to beat the market, but now it’s become “nearly impossible” according to Julie Segal at Institutional Investor magazine.
And Segal is speaking for the realm considered to be the last bastion of alpha—institutional investors, like Ivy League endowments.
Why has alpha been slipping away from even the brightest investment minds in the business? Charles Ellis, who served on Yale University’s investment committee from 1992 until 2008, tells Segal that volume on the New York Stock Exchange has increased more than 2,000 times in the past 50 years. Ellis also states that during the same time, the balance of trading in the U.S. has swung from 90 percent individuals to roughly 90 percent institutions.
In 1987, there were 15,000 people holding the coveted Chartered Financial Analyst (CFA) designation, the gold standard for money managers. Today, there are more than 110,000 CFAs worldwide.
It’s called the “paradox of skill.” As everyone’s skill increases, relative outperformance diminishes. Investors are smarter and more competitive than ever, and as a result, they’re unable to profitably exploit a dwindling number of market inefficiencies. The market has gone from being pretty darn efficient to ridiculously so.
Sadly, investors lose an awful lot of beta in their quest for alpha.
You have a choice: You can keep trying to climb Mt. Everest with a storm moving in and roller skates for footwear, or you can position probability in your favor and join the movement toward low-frequency trading and evidence-based investing.
If you enjoyed this post, please let me know on Twitter, @TimMaurer.
This commentary originally appeared April 17 on Forbes.com
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