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Why chasing high-flying investment managers is usually a really bad idea

When it comes to choosing an investment manager, looking for a hot hand is likely to leave you out in the cold.

The old market adage that past performance doesn't guarantee future results literally has never held more true, as no large-cap managers who beat the market indexes they use as benchmarks in 2013 managed to do so three years later.

That's right — none of them. It was zero, according to a study from S&P Dow Jones Indices.

Research on the performance of active investment managers in 2013 showed that of 1,034 large-cap funds, just 204, or 19.7 percent, topped the S&P 500's performance that year. Only 15.7 percent of the total managers outperformed the following year. In 2015, the number fell to 5.9 percent.

By 2016, not a single manager who outperformed in 2013 was able to beat the benchmark.


Bull Pamplona Spain
Miguel Riopa | AFP | Getty Images

"Taken together, the data indicate the difficulty market participants face in finding a skillful manager that can offer consistent alpha" — or a return that's better than the market benchmark — "on a near- to medium-term basis," said a paper authored by Ryan Poirier, senior analyst, and Aye M. Soe, senior director, both within S&P Dow Jones Indices' global research and design unit.

"Therefore, market participants may not be best served by chasing hot hands or picking managers based solely on past performance," they added.

The problems with active investment management in recent years have been well-documented.

Bailing on mutual funds

Fewer than 1 in 5 outperformed their benchmarks in 2016, continuing years of frustration since the financial crisis. A low-volatility market kept in check by aggressive Federal Reserve monetary policies have made it difficult for managers, who try to capitalize on price discrepancies.

As a result, active managers, who charge fees that are considerably higher than passive funds that follow market indexes, have come under fire. Investor money has fled active funds in droves, with 2016 seeing $340.1 billion in outflows while passive funds took in $504.8 billion, according to Morningstar.

This isn't the first time S&P has chronicled the difficulties of active managers' ability to meet their goals over time. And to be sure, S&P specializes in indexes, so it has an interest in the issue.

However, the study meshes with data collected by Bank of America Merrill Lynch and others that show consistent underperformance on the active management side.


Active struggles

Fund category
Benchmark
Outperformance 2013 (%)
2014
2015
2016
All domestic S&P Composite 1500 30.8 13.8 5.9 0.4
All large-cap S&P 500 19.7 15.7 5.9 0
All mid-cap S&P Mid-Cap 400 21.6 33 11.7 1.1
All small-cap S&P SmalCap 600 15.3 25.3 8.4 0
Real estate S&P U.S. REITs 6.7 57.1 28.6 28.6
Global S&P Global 1200 29.9 17.3 13.5 1.9
International S&P 700 34.6 32.2 20.7 5.8
Emerging markets S&P/IFCI Composite 34.2 27.8 13 3.7
Source: S&P Dow Jones Indices and CRSP

Large-cap core value funds showed the best performance for the 2013-2016 period, but even then, the results were fairly gloomy. Of 312 funds in the category, just 25.6 percent beat the S&P 500 in 2013, with outperformance among that group of 31.2 percent, 12.5 percent and 6.2 percent over the ensuing three years.

Funds that focus on real estate investment trusts had a better record of outperformance, though the sample size was small; just seven of 105 funds outperformed in 2013, with subsequent beats of 57.1 percent in 2014 and 28.6 percent in each of the following two years.

International funds fared better in 2013, though the ability to beat tailed off significantly in subsequent years.

Mutual funds still dominate total holdings

Though stock pickers have struggled, most investor money remains focused on mutual funds, about 95 percent of which are active in nature.

Total mutual fund assets excluding money markets stood at $13.6 trillion by the end of 2016, while exchange-traded funds, most of which are passive in nature, held $2.5 trillion, according to the Investment Company Institute.

The answer for investors looking to navigate through the active versus passive debate is to manage expectations and think longer term, said Diane de Vries Ashley, a corporate finance instructor at Florida International University.

"If you take the basic theory of portfolio management, it tells you time is your best friend," she said. "If you don't allow your friend to participate in your decisions, it's not fair."

Monitoring performance and being able to understand managers' actions also is key.

"If your manager is, over a period of say five to 10 years, doing pretty well by you, a partially down year is not a big deal," de Vries Ashley said. "If somebody's in the tank three, four years in a row, then you have some systemic issues."