Investing Knowledge

Most actively active fund managers under perform their benchmark index. To be fair to the blighters that doesn't mean they don't make some correct decisions that might be worth following. My earlier article this week highlighted the profitability of following fund managers' high conviction "best buys". 

In this article, we'll take a look at another aspect of fund manager capability -- they're not terribly good at deciding what to buy, but quite good when it comes to selling.

Do managers add any value?

The godfather of efficient market theory, Eugene Fama, famously criticized the fund management industry writing, "...even before costs there is no evidence that active managers can enhance returns." 

Burton Malkiel, economics professor at Princetown university added insult to injury, going as far as to say, "a blindfolded monkey throwing darts at a newspapers financial pages could ...do just as well (as fund managers)". Yikes! It's not just prize fighters who throw hard punches.

Good at running winners and cutting losers

Given that this fight has raged for decades, I'm really surprised anyone continues to step into the ring. Nevertheless, a few months ago Inalytics, a specialist research firm, unleashed their very best spreadsheet jockeys and set off to forensically analyse UK active funds to answer whether track records were down to skill or luck.

The research examined 215 conventional (long only) funds worth, in aggregate, £99 billion. Inalytics analysed every purchase and sale made by the fund managers to assess two measures of investment ability: the hit rate and the win/loss ratio. The hit rate is simply the number of right decisions as a percent of the total number of buy decisions. The win/loss ratio measures how much better the right decisions were compared to the wrong decisions.

The average hit rate (buying the right share, or over or under weighting the share) was 50% (49.6%). No more than flipping a coin. Apparently six out of ten is the industry standard for 'solid performance'. In fact the very best managers only managed a hit rate of 53%. Some of this may well be down to the over diversification I mentioned in my last article -- some of it is possibly down to ability.

Where managers, especially the good ones, did add value was maximising gains (from the winners) and minimising losses from the losers. This is seen in the win/loss ratio being 102%, which means the alpha from good decisions was 2% higher than that lost on the bad decisions. And whereas good managers were not that different from the average on their stock picking, on this measure the best managers had a win/loss ratio of 140%. In other words, the best managers know how to run winners and cut losers.

So how do you compare with fund managers?

Well, first of all take a good long look at your share purchases and sales over the last few years. How many made your money, and how many beat the index? If your success rate is over 50% you're doing well, if it's over 60% give yourself a well deserved slap on the back. I'll bet quite a few Fools passed that test. The second one is slightly harder. How did you 'manage' your losers? Did (A074130.KQ - news) you ruthlessly cut them out and move on to better opportunities, or cling on in the hope of 'recovery', a 'rebound' or just 'getting even'.

All the evidence on the trading patterns of private investors suggests they prune winners too early, and run losers for too long. Learn from the pros, acknowledge your bad decisions, take action and move on. Quickly.