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The Science and Art of Investing Can Harm Your Returns

Daniel Solin

In a recent New York Times column, Paul Sullivan commented on a report from Barclays Wealth and Investment Management with the intriguing title of The Science and Art of Manager Selection. The "art" is picking those active managers in the growth phrase, which is when they have had some success but haven't attracted an influx of funds that might change the way they invest. The "science" consists of a four-part analysis of "investment process", "organizational structure", "past returns", and "due diligence".

The complex details are exhaustively set forth in the report. No one could quarrel with the stated goal, which is "to add alpha, or risk-adjusted excess returns, of greater than 2 percent annually to readily available indexes over a market cycle." That would be pretty impressive.

But before you try this at home, it might be helpful to review the track record of others who have attempted to pick outperforming active managers. You would think that plan sponsors managing over $737 billion in assets could follow this art and science. Yet a study of approximately 3,400 plan sponsors over a ten-year period found that excess returns among newly hired managers were indistinguishable from zero.

Morningstar, a leading provider of independent investment research in North America, Europe, Australia, and Asia, should surely be able to select top fund managers likely to outperform. An unpublished study by Lipper Analytical Services looked at the performance of Morningstar's five-star stock mutual funds for the year after it received its five star designation. For the four-year period from 1990 to1993, a majority of the highly rated funds underperformed the stock mutual fund averages in the ensuing year. You can find a chart summarizing those results here.

Longer term data confirms the fact that only a relatively small percentage of outperforming managers repeat their performance in the year following their highly performing year. One study looked at the performance of fund managers from 1999 to 2010. Only about 15 percent of the top 100 managers from the one-year periods were able to repeat their top 100 performance in the second year. In 1999 and in 2007, no top 100 managers made the list in the following year.

If there was really a science and art to picking outperforming active managers, it's odd that most of the active fund managers can't adopt and implement a winning strategy. Historically, this has not been the case. Standard & Poors regularly issues a report on the performance of active funds. In its latest report, it found that 71.6 percent of all domestic equity funds failed to beat a style-based benchmark. The returns were about the same or worse for international equity funds, real estate funds, and fixed income funds.

There would be a benefit if you could find those relatively few active fund managers who will outperform their peers. But before you attempt this daunting task, you should be aware that the odds are stacked against you. As Bethany Mclean wrote in Fortune Magazine: "The truth is, much as you may wish you could know which funds will be hot, you can't -- and neither can the legions of advisers and publications that claim they can. That's why building a portfolio around index funds isn't really settling for average (or a little better). It's just refusing to believe in magic."

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book is The Smartest Money Book You'll Ever Read.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

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