As investors, we all have access to a staggering array of investment products and strategies. Although this range of choice can sometimes be overwhelming, ultimately these different approaches all fall into two broad classifications - (i) actively managed investments and (ii) passively managed investments.
Actively managed investing focuses on trying to "pick winners" - that is, selecting those investments (e.g. shares, bonds, funds) which are expected to have the best chance of outperforming the market as a whole. This often involves the use of highly skilled (and usually highly paid) professional fund managers and financial advisors whose job it is to identify those investments which are likely to deliver the best overall returns - whilst simultaneously seeking to avoid those opportunities which are expected to underperform. Active investors also aim to "time the market" in order to maximise returns and will therefore adjust their asset weightings and exposures in order to take advantage of market surges and contractions. While an active management style can involve a broad range of methods and techniques - whether it be so-called fundamental analysis of financial performance, technical analysis of trading patterns or macroeconomic analysis of market themes - all these approaches have the common goal of attempting to identify and profit from future investment trends.
On the other hand, passive investing does not focus on distinguishing between investment opportunities, forecasting likely prices or timing the market. Rather than selecting individual investments in an attempt to outperform a particular market index, passive managers invest broadly within and across the entire index of interest. They literally "buy the whole index" in which they are interested, allocating their funds across every share/bond in the same proportion that those shares/bonds represent of the index that they are seeking to track. In doing so, passive investors ensure that their portfolios mimic the performance of their targeted index. While this means they trade off the opportunity to "outperform the market", it also ensures they avoid the risk of significantly underperforming the market at the same time.
At Six Park, we are strong advocates of passive investing - although, as outlined later, we believe this approach should be overlayed with an engaged, thoughtful and continuously reviewed approach to asset allocation and portfolio management.
Whilst "picking stocks" and "timing the market" can deliver strong performance from time to time (and can therefore have a place in an investor’s strategy), the odds of being able to consistently and meaningfully outperform a passive investment approach are slim - particularly over the longer term and once trading costs and fees are taken into account. In our view, it is extremely difficult to pick winners and/or time the market - even for the most skilled professional fund managers and advisors.
There is a growing body of research - both in Australia and around the world - which shows that the vast majority of active managers do not outperform the market on a consistent and persistent basis. For example, a recent study by S&P Dow Jones Indices LLC found that almost two thirds of mutual funds in the US failed to outperform their benchmark index over the last one and three years, and over 75% of all funds underperform their benchmark over five and ten years. 1Similar studies in Australia by S&P Dow Jones have found that the vast majority of active funds in most categories (including domestic shares, international equities and Australian bonds) have failed to beat their comparable benchmark indices over similar periods. 2
Percentage of Funds Underperforming their Benchmark Index
While a very small minority of fund managers manage to "beat the market" from time to time", such outperformance tends not be sustained for extended periods. It is also nearly impossible to identify in advance which managers/funds will outperform the market for a particular period.
For example, a recent study by S&P Dow Jones 3found that less than 5% of the highest performing funds managed to retain their top quartile ranking after three years - with only 0.28% (i.e. 2 out of the 703 top quartile mutual funds!) maintaining top quartile performance for the full five year period. The data also showed a strong likelihood for the better performing funds to become the worst-performing funds over time- with over 25% of the initial top quartile funds becoming bottom quartile funds by the end of the five year period.
Similarly, there are numerous studies which have shown the challenges associated with trying to "time the market". For example, a recent study by JPMorgan 4showed that an investor who stayed fully invested in the S&P500 index from 1993 to 2013 would have earnt an annualised return of 9.2% - even including the impact of the GFC. However, if that investor missed out in being invested during the ten best market days during that period, their annualised returns would fall to just 6.1%. Missing best 40 days - just over 1% of the total trading days - would have entirely eliminated any gains made over the period!
This highlights the real difficulties and risks of attempting to time the market. Even a simple decision like deferring an investment "until the market recovers" could just as easily mean missing out on those crucial days or weeks when the market surges - a narrow window of opportunity which most of us are unlikely to anticipate and which could have a material impact on overall investment returns. This assumes you are successful in timing your market exit in the first place - which is certainly not assured either.
Ultimately, the biggest problem with trying to time the market is that you actually have to be correct not just once but twice. First, you have to ensure you sell at the right time (i.e. at or near the market top) and then secondly, you have to get the timing right in terms of buying back in when the market bottoms. The likelihood of getting these moves right is very low. Even professional portfolio managers rarely get this right on a consistent and repeatable basis. While obviously no strategy can guarantee a profit or protect against loss, history suggests that it is time in the markets, not timing the markets, which matters most when building wealth for the long term.
Of course, we are not alone in our support for passive investing. Even Warren Buffet, arguably the richest man ever to make his fortune through investing, has set out in his will that all money bequeathed to his wife is to be invested via a low-cost, passive investing approach. His own view is that "…the long-term results from this policy will be superior to those attained by most investors - whether pension funds, institutions or individuals - who employ high-fee managers." 5