Can investors pick good stock-pickers?

Active managers may beat the market, but whether they're good or just lucky is another question

Can investors pick good stock-pickers?
While the success of passive funds isn’t expected to wane anytime soon, there has been some news of stock-pickers succeeding in 2017. But while a fund’s success could be based on shrewd choices or mere chance, most people assume they really can pick winners.

Take for example a simple experiment conducted by Victor Haghani, CEO of index-based investing firm Elm Partners, along with two colleagues. They told several hundred acquaintances who worked in finance that they would flip two coins: a normal one and a weighted one that would turn up heads 60% of the time. They then asked how many flips it would take to figure out which was which with a 95% confidence level, reported the Wall Street Journal.

When asked to give a “quick guess,” nearly a third answered it would take fewer than 10, and the median response was 40. The correct answer was 43.

“The research applies directly to picking fund managers,” the Journal report said, noting that even though most active managers fail to beat the market, many investors are willing to pay fees for managers they believe are skilled enough to do so.

As an example, Bruce Berkowitz was recognized as the domestic equity fund manager of the decade by Morningstar in 2010. His Fairholme Fund had beaten its benchmark most years, managing a compound annual return that was 13% better than that of its peers on an annualized basis. But the very next year, the fund lagged behind the S&P by nearly 35%.

Two years later, Mark Hebner of Index Fund Advisors conducted statistical analysis to determine whether Fairholme’s past success was due to skill. Based on the fund’s deviation from its benchmark and using a 95% confidence interval, he determined that it would take 18 years to get an answer; for funds with even greater return volatility than Berkowitz’s, Hebner found it could take several centuries.

Other factors could come into play. Over time, specific strategies like value investing could rise and fall in popularity. An effective investment strategy could also become less potent as more people try to imitate it.

“The confidence investors place in their ability to pick skilled managers is ultimately costly,” the Journal said. “Investors buy top-performing and top-rated funds without any ability to determine if skill or luck produced the gains. The result is that the typical investor in active funds lags behind even those funds’ return by quite a bit.”

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