in my last video I talked about some of
the challenges that active managers face
in performing the market it boils down
to their relatively high fees and
intense competition from other managers
there's another less obvious reason that
active managers have so much trouble
beating the market we know empirically
but a small number of stocks in the
index tend to drive the performance of
that index so trying to select stock in
an index dramatically increases the
probability of underperforming that
index when trying to pick stocks in an
index in an effort to beat the index the
likelihood of underperforming is much
greater than the likelihood of
outperforming this research was
published in a 2017 paper by Heaton
Polson and Witt titled why indexing
works and it is yet another blow to
active management I'm Benna Felix of PWL
capital and this is common-sense
investing
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if we look at data on market returns the
basis of this research is clear most of
the markets returns come from a small
number of stocks let's look at an
example using data from the global stock
markets between 1994 and 2016 over that
time period global stocks returned an
average of 7.3 percent per year not bad
if we remove the top 10% of stocks in
that global market portfolio the average
annual return drops to two point nine
percent exclude the top 25 percent and
the average annual return drops to a
much less exciting negative 5.2 percent
of course it would be great if an active
manager could identify those top
performing stocks ahead of time but
we've seen the data around their ability
to do so it doesn't look very good we
know that in most cases active managers
performance can be attributed to luck
rather than skill a lucky manager has
been fortunate to randomly select stocks
that have done well in their paper
heaton Polson and way out a very simple
example explaining the challenge to the
active managers face based on what we
know about market returns if we have an
index consisting of five stocks and
assume that four of them will return 10%
and one will return 50% over a given
time period and we then suppose that
active managers are going to create
portfolios using either one or two of
those stocks and equal weights there
will be a set of 15 possible actively
managed portfolios from stocks men index
10 to the 15 portfolios what are in a 10
percent return due to omitting the 50
percent returning stock and 5 of the 15
portfolios will earn either a 30 percent
or a fifty percent return due to holding
the 50 percent stock depending on
whether it is a one or two stock
portfolio in this example the average
return of the stocks in the index and of
all active fund managers is 18 percent
before fees just like we would expect
all active managers together get the
return of the market but when we look at
each portfolio individually two-thirds
of the actively managed portfolios will
underperform the index due to their not
holding the 50 percent returning stock
which is always included in the index
closet indexing is the result of active
managers owning the market like an index
fund for charging active management
level fees a strategy that is guaranteed
to lose to differentiate themselves from
closet indexers some active managers
will
pitch themselves as having high
conviction or high active share meaning
that they are very different from the
index the research that we've discussed
in this video shows that even if you're
able to find an active manager that is
truly active and has low fees there's a
relatively low probability that they
will be able to deliver market meeting
performance with this high probability
of underperformance finding a skilled
manager which we already know to be
beyond challenging becomes increasingly
important fees typically take the blame
for the systemic under performance of
active managers but this research
demonstrates another big hurdle that
needs to be overcome to beat the market
in fact of managers miss out on a
relatively small proportion of top
performing stocks there's a significant
risk of trailing the market in my next
video I'll be talking about downside
protection one of the most prolific
sales pitches in the investment
management industry day index funds
protect your downside join me to find
out my name is Ben Felix of pwl capital
and this is common sense investing I'll
be talking about this and many other
common sense investing topics in this
series so subscribe click on the bell
for updates I'd also love to hear from
you as to what topics you'd like me to
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