Like most people nowadays, I spend a fair amount of my time each day on specific social media platforms. Admittedly, I tend to gravitate to following other people in the financial services and investment space. I suspect it’s as much a curiosity thing as anything else but I’m interested in seeing if I can get down to the bottom of some big outstanding questions that I’ve had forever. One of those questions is why DO active money managers struggle to beat the S&P 500?
Let’s face it, most of the individuals who are on Wall Street buying and selling for institutional investment portfolios and investment funds have a certain pedigree. They are from select elite colleges and quite frankly…they’re smart.
My two past bosses when I was associated with that world were from elite high schools, prep schools and then colleges. In fact, Columbia and the Wharton School of Business. They WERE smart individuals.
So with this curated pedigree and access to personnel of equal distinction to assist them, along with research capacity that is unequaled, why do active money managers struggle to beat the S&P 500 each year?
Well, I’m pretty sure you wouldn’t be surprised if I told you that I didn’t find any answers to this question on the social media platforms.
In fact, all I found were more claims as to how people were beating the market by using their ‘patented’ trading systems. That’s even more ludicrous in light of the fact that these individual’s investment track record is not publicly monitored like other money managers who oversee publicly traded funds..
So with so little verified and factual information out there as to why active money managers do not beat the S&P 500 each year, I’ve put together some observations from my own research on the subject.
1. The Efficient Market Hypothesis:
The Efficient Market Hypothesis (EMH) suggests that financial markets are efficient and all relevant information is already incorporated into stock prices. More specifically, it identifies that due to this market efficiency that it is difficult, if not impossible, for active money managers to consistently beat the market.
The EMH theory further asserts that any active money manager that outperforms the market is a result of luck rather than skill.
Although a bit harsh perhaps, the theory infers that there wouldn’t be any additional information that an active money manager could glean that the market hasn’t already taken account of in the pricing of the underlying stock.
Research done by Nerd Wallet revealed only “10.62% of funds outperformed the S&P 500 in the last 15 years”.
2. Costs and Fees:
Active money management involves higher costs and fees compared to passive investing. Active managers often engage in frequent buying and selling of stocks, which leads to higher transaction costs inside the fund.
Additionally, active management fees that are charged to investors of the fund tend to be higher due to the resources required for in-depth research, analysis, and portfolio management.
These costs eat into the returns generated by active managers, making it more challenging for them to outperform the S&P 500 consistently. Nerd Wallet has a great article about how this whole dynamic works at Index Funds vs. Mutual Funds: The Differences That Matter – NerdWallet
3. Diversification:
The S&P 500 represents a diversified portfolio of 500 large-cap stocks across various sectors of the U.S. economy. By investing in the entire index, passive investors automatically achieve broad diversification.
In comparison to this, active managers may struggle to achieve the same level of diversification within their fund due in large part because of the directive of their investment mission which might favor a higher concentration in a certain industry sector or additional weighted investment in particular stocks in order to fulfill higher ‘expected’ returns, like technology as an example.
This lack of diversification can increase risk and hinder their ability to consistently beat the S&P 500.
4. Behavioral Biases:
Human psychology plays a significant role in investment decision-making. Active money managers are susceptible to various behavioral biases such as overconfidence, confirmation bias, and herd mentality.
These biases can lead to suboptimal investment decisions, such as chasing high-flying stocks or selling winners too early. In contrast, passive investing is based on following a defined composite of stocks like the S&P 500 Index.
Seeing that there’s no need to trade within the fund, the passive investor is not tempted by news, good or bad, of an individual stock or about an industry sector.
5. Lack of Consistency:
Even if active managers occasionally outperform the S&P 500 in certain periods, it is extremely difficult for these managers to outperform it over the long term or even from one year to the next.
has been substantiated in multiple studies over the years and is chronicled extensively and professionally by an organization called SPIVA SPIVA: 2022 Year-End Active vs. Passive Scorecard | Index Fund Advisors, Inc. (ifa.com)
In addition, the changing dynamics of the market, evolving economic conditions, and the unpredictability of individual stock performance make it difficult to consistently beat the benchmark.
6. Market Efficiency and Information Access:
The rise of technology and the accessibility of information have contributed even further to increased market efficiency. Large institutional investors, such as pension funds and mutual funds, employ sophisticated research teams and have access to vast amounts of data and analysis.
These resources which are now widespread across all the trading houses have evened the playing field throughout the financial services industry, making it harder for all active managers to gain an informational advantage.
The efficient dissemination of news and the prevalence of algorithmic trading further reduce the opportunities for active managers to exploit pricing discrepancies.
7. Wall Street Hubris:
This may sound unbelievable to many but after having spent a stint of my own with a Wall Street firm, I came to realize that Wall Street has its own code of operations. Many of the aspects of this code would seem to be antithetical to what most of us would think happens on Wall Street, which we would otherwise believe is a disciplined and regimented approach to handling other people’s money.
To the contrary, because there are a lot of promises made to large institutional investors to deliver larger returns with their invested dollars some truly interesting decisions get made.
As such, there is a massive amount of pressure to deploy each and every dollar as quickly as possible into investment vehicles and this urgency fuels the bad decision making.
Many of these active money managers would rather take a higher level of risk to put these funds into the market than to keep them in cash and underperform the market, which as we have discussed herein, they are more than likely to do anyways.
As a result, many active money managers make hasty investments just to have these funds deployed.
Conclusion:
While there may be some active money managers who occasionally outperform the S&P 500, the odds are stacked against them. The Efficient Market Hypothesis, higher costs and fees, lack of diversification, behavioral biases, lack of consistency, market efficiency and hubris collectively contribute to the challenge of consistently beating the benchmark.
As a result, passive investing offers for a ‘set it and forget it’ investment model where just owning the market or a portion of the market will allow the investor to at least match the performance of that particular benchmark.
In addition, that strategy doesn’t normally include an active trading component so fees are all but eliminated and the cost to control such assets are minimal to the retail investor.
Another aspect that is challenging for many active money managers is that in many cases because they have so many resources to invest, most cases caused by funds coming in weekly/bi-weekly from ERISA enabled investing programs such as 401(k)’s, the funds themselves are so large that they have a fair amount of overlapping on investments and inadvertently create more risk and exposure to certain parts of the market.
This can have a huge impact on a funds performance if that specific stock or industry is trending downward.
