The world is full of investment pornography. This is a term coined by a mutual fund marketing executive I know to describe misleading claims in the investment industry. One such claim is that smart, hard-working investment managers with cutting-edge technology can outperform the market by actively trading stocks or other investments. Although it seems intuitive that this approach would produce positive results, the evidence indicates differently.
I started my career working in equity research for a large investment bank. We were perennially ranked as one of the top research departments on Wall Street. Every year our group would put together a fund that invested in the top ideas from the entire research department. We formed a committee made up of research management, the strategists, economists and market technicians. On average, each of the committee members had roughly 30 years of Wall Street experience. Each of the analysts in the department, who followed stocks in various industry groups, presented their best ideas for the coming year to this committee. The committee ultimately selected what it viewed as the 15 most promising stocks for inclusion in the fund.
This was about as rigorous a process as you could imagine: The top people from one of the leading firms using their best ideas, significant technological resources and decades of experience. The result: The fund usually underperformed the S&P 500.
We were not alone. When you look at the objective data, it turns out that a large majority of professionally managed investment products fail to provide returns in line with or above what you could get by using a naive index fund.
The problem, largely, is that all of the required ingredients for outperformance are expensive. Smart portfolio managers and analysts don’t come cheap. Neither does cutting-edge technology. So just to earn the return of the market, professional investors must perform significantly better on a gross-of-fees basis. A high level of trading activity, which is characteristic of most actively managed funds, can also result in significant tax expense…