As evidence-based investors, we know that in aggregate, the relative performance record for active mutual fund managers is dismal. Depending on the asset class in question, roughly 80%-90% of active equity managers have underperformed their benchmark index in any given 10-year period, and these poor results are actually worsening over time. The amount of the underperformance is also highly correlated to the level of management fees these managers charge (i.e. investors are definitely not getting what they paid for!)
At the same time, there is no denying the stellar performance records of a handful of active managers, with Warren Buffett’s record a notable standout. Mr. Buffett, through his investment company Berkshire Hathaway, has so trounced his benchmark (the S&P 500 index) that you need to use a logarithmic scale to keep his performance line on the same chart:
While the S&P 500 is up more than 2,300% since 1964, Berkshire Hathaway stock is up a stunning 1,000,000% in the last 53 years. Some critics of evidence-based investing might argue that Buffett’s record proves market prices are not efficient, and that some active managers clearly show skill at ‘beating the market’. Does this kind of record invalidate our investment philosophy?
First, it is important to know that believing market prices are efficient does not mean that some active managers will outperform their benchmark index. In fact, it is fully expected that a proportion of them will outperform in each period (although that proportion will tend to be less than 50%). However, market efficiency does suggest that (1) you cannot consistently predict which managers will outperform beforehand and (2) manager outperformance in one period does not tend to persist (carry forward) into the next time period.
Secondly, we can turn the question of Warren Buffett’s track record on its head and instead ask “Why aren’t there more managers like him out there?” In other words, why is a long-term track record of outperformance so exceedingly rare among active investment managers? In fact, they are so rare that the handful of managers that do attain this status become quite famous (e.g. Peter Lynch at Fidelity, George Soros at Quantum Endowment, Bill Miller at Legg Mason, and Ray Dalio at Bridgewater). You can easily fit all of their names on an index card!
And finally, not to impugn Mr. Buffett’s amazing record, it is nonetheless interesting to note that the vast majority of his outperformance occurred in just one 5-year period – circa the late 70’s. Since then, as the following chart shows, it appears to be getting more and more difficult to maintain the same record of outperformance, even for a world-class investor like Mr. Buffett:
Investment performance records like Mr. Buffett’s were already quite rare, but now may be a thing of the past. One reason for the decline in outperformance (as shown on the above chart) is that the investment management industry is hyper-competitive, and getting more so with each passing year. Strategies that relied on discovering undervalued gems are rapidly disappearing. For the typical investor, trying to choose which active manager or mutual fund will outperform (among thousands of potential candidates) for the next ten or twenty years is likely to be an exercise in frustration.
The really good news for investors is that it is also entirely unnecessary in order to have a successful investment experience – because the risk premia are already there for the taking. Rather than searching for the next star manager, one need only design a globally diversified portfolio with exposure to certain risk factors (such as the market, size and value premiums) that have rewarded patient investors over the long term. Coupled with a disciplined rebalancing strategy, this type of approach is much more likely to achieve your financial goals.