Why Would You Ever Invest With An Active Manager?

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Most active investment managers underperform the market. It’s even worse after taxes. But you know that already. So why would you ever invest with an active manager?

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Because the best ones trounce the market. They have produced returns up to 5%+ per year above that of the index funds over decades.

A quick hypothetical exercise: at 10% per year, the oft-quoted long-term return level for the U.S. equity market, $100K would grow to about $1.7M in 30 years. At 15% per year, the same amount would grow to $6.6M. That’s a life-changing difference for many.

The skeptics reject such arguments. They claim the winners all got lucky. There is no way to predict in advance who is going to be the manager who beats the market, and who will be among the vast majority that delivers returns around the level of market less fees.

This is not a new question. In 1984, Warren Buffett gave a well-known speech titled The Superinvestors of Graham-and-Doddsville. Benjamin Graham is the father of modern value investing, who together with David Dodd wrote the seminal work in the field, Security Analysis.

Warren Buffett was Graham’s best student when the latter taught a course on Security Analysis at Columbia Business School. But he was not Graham’s only successful student. Graham taught a number of other value investors who went out and produced successful long-term track records for their clients.

In Superinvestors, Buffett makes the following refutation of “they got lucky” argument. He admits that sure, if thousands of monkeys were flipping coins and wagering on the outcome, there would be after thousands of flips a small number of lucky monkeys who will appear to be skilled. They might even come up with fancy theories about their methods and why they are so good at this seemingly random endeavor.

Of course, there is no way to be skilled at flipping a fair coin. So these monkeys would be fooled by randomness.

But wait, says Buffett. What if most of the winning monkeys had come from the same zoo, taught by the same zoo keeper? Would that not pique your curiosity?

You might then posit that maybe they all copied one lead monkey in terms of the precise sequence of heads vs. tails. Or to move the analogy to the investing world, maybe they had near-identical portfolios.

Well, the “monkeys” in Buffett’s analogy are Graham’s students of value investing. Somehow, despite the vast majority of active managers failing to beat the market, this group had done so in spades.

What’s more, over time their portfolios were quite different. So it wasn’t the case of one skilled (or lucky) investor whom the others were imitating. It was the case of an investing philosophy that each investor then implemented in ways best suited to their own understanding and circumstances.

If you want to search for a disproportionate concentration of long-term records that have beaten the market, look among value investors. That’s a bit difficult to ascribe to mere luck.

Article by Behavioral Value Investor.

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