Posted by on Oct 24, 2016 in Articles & Advice, Blog, Featured, Posts |

By Jason Zweig | Oct. 21, 2016 1:07 pm ET

Image credit: Poster for “The Incredible Shrinking Man” (Universal Pictures, 1957), Wikimedia Commons


One under-appreciated aspect of the index-fund revolution: A growing body of research on what drives stock returns has made it easier than ever for investors to determine whether fund managers are skillful or just lucky.

The central insight: Portfolio managers don’t just pick one stock at a time; they pick particular types of stocks.

Researchers have identified several factors that determine which stocks perform better than the market as a whole. Looking at decades of data from markets worldwide, finance professors and investment analysts have determined that, on average, small stocks do better than large; so-called value stocks, trading at low prices relative to what their underlying assets are worth outperform those trading at higher prices; so-called momentum stocks, whose share prices have recently been rising faster, continue to outperform; and “quality,” or highly profitable, companies tend to earn higher stock returns as well.

Let’s picture an imaginary fund manager named Roland E. Dice. He’s kind of a dope. He doesn’t really know how to pick stocks, but he likes buying smaller stocks because they make his portfolio look distinctive. He isn’t skilled; he’s just guessing.

In the long run, the Dice Fund might well outperform not because Mr. Dice knows what he’s doing but because he just so happened to load up on small stocks, which over time tend to do better than the overall market.

The Dice Fund could easily outperform the S&P 500 by an annual average of a percentage point or two merely because it invests in small stocks — not because Mr. Dice is any good at picking which small stocks are better than others.

In the old days, when analytical tools were cruder, investors would have looked at that outperformance and lionized Mr. Dice as a brilliant stock picker.

But nowadays, anybody can just go and buy an index fund of small stocks for next to nothing. Instead of betting that Mr. Dice will stay on his hot streak, you can just own the source of his returns directly. In finance geek-speak, his “alpha,” or excess return over the market adjusted for risk, has become “beta,” the return of an index itself.

In an article last year and, at greater length, in his book The Incredible Shrinking Alpha, Larry Swedroe, director of research at Buckingham Asset Management, a financial-advisory firm in St. Louis, points out that any actively managed fund can now be analyzed this way. A portfolio of stocks can be systematically broken down into the factors that drive its returns: how small its stocks are, whether they are value or growth, momentum or quality, and so on.

Consider Fidelity Contrafund, whose manager, Will Danoff, I profile in this weekend’s “Intelligent Investor” column. His impressive long-term results — outperforming the S&P 500 by an average of 2.9 percentage points annually over the past 26 years — lose a bit of luster when you analyze them with the latest techniques.

Adjusting for the riskiness, size, valuation and recent momentum of Contrafund’s holdings, its outperformance drops to 1.9 percentage points annually since 1990, according to Wharton Research Data Services, a financial-analysis group at the University of Pennsylvania. That’s still impressive, although no longer eye-popping.

Recently introduced exchange-traded index funds specializing in large growth companies with high momentum could probably come close to mimicking Contrafund’s future performance unless Mr. Danoff discovers a new source of return or changes his style, says Mr. Swedroe. He doesn’t own the fund.

Viewed this way, almost every active stock picker becomes effectively interchangeable with an index fund or a combination of them charging much lower annual fees.

Has an active manager done well on very large, high-growth stocks? You could replace his fund with Vanguard Mega Cap Growth ETF. Do you own another fund that has thrived by investing in highly profitable companies with stable earnings growth and low levels of debt? Chances are, iShares Edge MSCI USA Quality Factor ETF will provide similar returns.

As Mr. Danoff says in my column, he doesn’t think what he does can be replaced by an index fund or a mix of them — and even Mr. Swedroe agrees that Mr. Danoff’s track record lends some credence to that.

But what happens to the thousands of mediocre active managers once the investing public wakes up to the fact that most of them can be effortlessly replaced at low cost?

Perhaps the economist Paul Samuelson put it best more than four decades ago when he wrote:

“A respect for evidence compels me to incline toward the hypothesis that most portfolio decision makers should go out of business — take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives.”

Added Samuelson wryly, “Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed.”

A few years from now, your plumber may be a former mutual-fund manager.

Source: MoneyBeat blog,