Why Mutual Funds Don’t Beat the Market

October 9, 2012
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“I spoke with a professional whom I consider one of the best in the business, a friend I’ll call Bob (even though his real name is Rich). Bob is in charge of $12 billion of U.S. equity funds at a major investment firm. For some perspective, if you went to the racetrack and placed a bet with $100 bills, $12 billion would stack twenty World Trade Centers high (needless to say, a bet that would almost certainly kill the odds on your horse). According to Bob, the bottom line and measure of his success is this: How does the return on his portfolio stack up against the return of the Standard & Poor’s 500 on average? In fact, Bob’s record is phenomenal over the past ten years as his average annual return has exceeded the return of the S&P 500 by between 2 and 3 percent.

“At first blush, the word “phenomenal” and an increased annual yield of 2 or 3 percent seem somewhat incongruous. Though it is true that after twenty years of compounding even 2 percent extra per year creates a 50 percent larger nest egg, this is not why Bob’s returns are phenomenal. Bob’s performance is impressive because in the world of billion-dollar portfolios, this level of excess return is incredibly hard to come by on a consistent basis. Some quick calculations help expose the limitations imposed on Bob by the sheer size of his portfolio. Imagine the dollar investment in each stock position when Bob sets out to divvy up $12 billion. To create a 50-stock portfolio, the average investment in each individual stock would have to be approximately $240 million; for 100 stocks, $120 million.

“[Circa late 1990s] there are approximately 9,000 stocks listed on the New York Stock Exchange, the American Stock Exchange and the NASDAQ over-the-counter market combined. Of this number, about 800 stocks have a market capitalization over $2.5 billion and approximately 1,500 have market values over $1 billion. If we assume Bob does not care to own more than 10 percent of any company’s outstanding shares (for legal and liquidity reasons), it’s likely that the minimum number of different stocks Bob will end up with in his portfolio will fall somewhere between 50 and 100. If he chooses to expand the universe from which he chooses potential purchase candidates to those companies with market capitalizations below $1 billion, perhaps to take advantage of some lesser followed and possibly undiscovered bargain stocks, his minimum number could easily expand to over 200 different stocks.

“Intuitively, you would probably agree that there is an advantage to holding a diversified portfolio so that one or two unfortunate (read “bonehead”) stock picks do not unduly impair your confidence and pocketbook. On the other hand, is the correct number of stocks to own in a “properly” diversified portfolio 50, 100, or even 200?

“It turns out that diversification addresses only a portion (and not the major portion) of the overall risk of investing in the stock market. Even if you took the precaution of owning 9,000 stocks, you would still be at risk for the up and down movement of the entire market. This risk, known as market risk, would not have been eliminated by your “perfect” diversification… after purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small…

“From a practical standpoint, when Bob chooses his favorite stocks and is on pick number twenty, thirty, or eighty, he is pursuing a strategy imposed on him by the dollar size of his portfolio, legal issues, and fiduciary considerations, not because he feels his last picks are as good as his first or because he needs to own all those stocks for optimum portfolio diversification.

“In short, poor Bob has to come up with scores of great stock ideas, choose from a limited universe of the most widely followed stocks, buy and sell large amounts of individual stocks without affecting their share prices, and perform in a fish bowl where his returns are judged quarterly and even monthly.

“Luckily, you don’t.”

- Joel Greenblatt, You Can Be a Stock Market Genius

JS Comment:

As with “How to Get Rich” by Felix Dennis, “You Can Be a Stock Market Genius” is another excellent book with a silly title.

The book quickly developed a cult following in the late 1990s, in part because of the highly useful material — a focus on special situation investments such as spin-offs, mergers, stub stocks, restructurings etc — and in part because of Greenblatt’s track record with hedge fund Gotham Capital, which achieved 40% annual returns over a 10 to 20 year period.

The traditional mutual fund industry is essentially a fee and asset-gathering exercise, as Greenblatt’s example makes it plain to see. From an incentive perspective, huge size is logical for a mass-market business model, but not for individual investors within the funds.

The other major problem, for the average individual investor, is not enough real talent to go around. When trillions have to be put to work, and truly performance-oriented managers are deliberately restricting their size, likely running hedge funds limited to accredited investors, and are relatively few in number in the first place, there is little Joe Sixpack can do other than take the mass-market option… which in turn provides the research data that most academic theory is based on.

On the bright side, what does this say about inherent potential for the skilled and nimble practitioner, unencumbered by the shackles of institutional size, the burden of committee-vetted mandates, and the straitjacket nature of benchmark risk?

Buy You Can Be a Stock Market Genius on Amazon

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2 Responses to Why Mutual Funds Don’t Beat the Market

  1. CJ London on February 1, 2013 at 6:45 am

    Lots of assumptions here that miss the real point entirely. Such as; only looking at US portfolios,
    assuming 1990′s market cap sizes are still relevant for 2012 and beyond,
    assuming equally weighted portfolio of (only) $2.5B mkt cap stocks, assuming mutual funds cannot use other instruments,
    assuming that smaller stocks on other boards are off limits.

    Today there are plenty of US stocks well above the $100′s of billions market cap, managers can go off benchmark and hold pools
    of nascent small caps, managers can use derivatives or ETFs or even other funds within certain limits, managers can take big
    ownership positions in firms if they want.

    My opinion, frankly, is that there is an asymmetric risk/ reward for managers (meaning the PMs and their firms). They can stick their necks out and bet big, maybe win big and make big money,
    maybe lose big and ruin their reputation for keeps. take a job in middle office. OR they can make little closet benchmark hugger bets… loads of little
    basis point piddly positions all over the shop backed by mountains of analyst research….tank with their peers when market tanks, slightly outperform the mkt with their
    peers when mkt goes up…make a bit less money but still able to drive the Porsche to country club for rest of life regardless of whether they get it right or wrong.

    • Jack Sparrow on February 7, 2013 at 7:29 pm

      Except the assumptions didn’t really miss the point, because mutual fund managers are typically heavily restricted in their choice of exotica, and as for your last paragraph, yes, a biz in which there is excellent optionality for the manager, with the ability to keep the porsche even if performance is shitty, is a win for the industry rather than for investors. So there isn’t really a meaningful dispute here…

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