Energetic Investment Managers Could Increase ROI
All over Wall Street, investors make reference to managers who over- or under-perform their benchmark indexes by as little as 1% to 2% per year. This seemingly minute amount begs the question: how big of a difference does 1% to 2% per year actually make? Although small percentage differences in the short-term may seem relatively insignificant, the long-term effect of even marginal over- or under-performance is staggering. The reason for the large effect of small differences in investing is due to what Albert Einstein allegedly described as the most powerful force in the universe: compound interest.
Just After 15 Years…
After fifteen years, an investment of $10 million earning four percent a year compounded is worth just over $18 million. This type of return would in all likelihood outpace inflation and protect a person’s purchasing power (which is by no means something to scoff at, especially in light of our most recent decade’s market returns). A 1% and 2% outperformance over this base case, however, yields an additional $2.78 million and $5.96 million, respectively, by year 15. In other words, over a 15-year period, a 2% annualized outperformance translates into a 60% cumulative outperformance.
The effects of compound interest go both ways. A two-percent under-performance is detrimental to the same extent that a two-percent out-performance is beneficial. If an investor allocates to a manager who goes on to be out-performed by the passive index (like the S&P 500) by two-percent a year, then, using the example above, that investor effectively losses almost $6 million of his or her money.
When it comes to investment returns, the margins are small but the stakes are high. As a result of the “miracle” of compounding, little differences go a long way. So how good are investment managers at providing the little differences to their investors? As the next section discusses, investment manager out-performance is more elusive than most believe.
The Bad News: Even Little Differences are hard to Come By.
Selecting investment managers is not for the casual consumer or the faint-of-heart. The main issue for investors looking to get their money’s worth investing in active funds is that, over the long-term, the average investment manager underperforms the no-fee benchmark index. As a result, investors in the average fund are consistently better off forgoing the whole investment manager selection process and just putting their money in an index.
Taking a deeper look, in fixed income, even the top quartile investment manager provided clients with a losing strategy over the ten year period. The time span from 1995 to 2005 is not unique. The average investment managers in the largest asset classes simply fail to earn their keep over time. Only the top performing investment managers provide a worthwhile service.
Investors can earn superior returns if they are able to discern which managers will go on to significantly outperform their peers, but these managers are surprisingly scarce.
Rule #1: when investing in the Traditional asset classes, only allocate to an investment manager if you are convinced the manager will go on to beat its peers by a wide margin.
There is an intuitive explanation for this data explaining investment manager performance in Traditional equities and fixed income. The most popular asset classes are the ones in which managers have the biggest headwind in trying to “beat the market”. Take the international fixed-income market for sovereign bonds, for example. In this market, investors try to decide which country’s sovereign debt is the cheapest or most expensive and weigh their portfolios accordingly. The problem for investment managers in this market is that the phenomena that determine the bond prices are among the most monitored phenomena in the world without considering the money tips widely prevalent.
Getting an edge over the competition under such circumstances is exceptionally difficult. The source of disparity in top quartile performance among asset classes is the relative “efficiency” of each market. Market “efficiency” has to do with the number of independent investors who buy and sell from each other and how easily information flows among them. The more efficient a market is, the harder it is for managers to beat the competition because there is a more equal playing field. The opposite is true for less efficient markets.
Instead of fretting over which markets will render inefficient returns, leave your worries in the hands of efficient investment managers who’ve circumnavigated the world of fiduciaries, stocks, EFT’s and everything you know little about. Many more frugal tips are available from managers of this caliber, too.