Last year, I ran a seven-day race in the Sahara Desert. The second most-common question I got about the race was, “How did you get all the water you needed?” (The most common question was “Why—are you crazy?!”)
I explain that I drank water along the way, and I try to avoid addressing the fallacy that you need at least eight glasses of water a day. (There are actually no scientific data to support this conventional wisdom. In fact, most of the recommended daily quantity of water—about 2 liters per day—is contained in prepared foods.)
Focus on the facts
Conventional wisdom doesn’t always consider the facts. We hear a myth, and once it becomes ingrained in us, we accept it as fact. As another example, perhaps you’ve also heard of this myth: “The less efficient a market is, the more likely that an active manager will be able to outperform.”
Conventional wisdom tells us that this is an understandable argument. Because there will be fewer informational efficiencies in an inefficient market, the odds of finding a manager with an “informational edge” who can consistently beat the market will be greater.
However, the historical performance of active managers in U.S. small-cap and emerging market equities suggests that conventional wisdom can be wrong.
The zero-sum game holds in inefficient markets
Let’s take a step back and remember that the stock market is a zero-sum game. For every dollar that is actively overweighted to a stock in any equity market segment, there must be an equal offsetting dollar that is actively underweighted to that same stock.
In aggregate, for every profitable trade an investor makes, another investor is taking the opposite side of that trade and incurring a loss that’s equal to the other investor’s gain. So while there may be informational advantages in inefficient markets, providing more opportunities for outperformance, investors are still subject to market-participation costs that offset the advantages. These costs include management fees, wider bid/ask spreads, administrative costs, commissions, market impact, and, where applicable, taxes. As such, even if theoretical advantages exist in inefficient markets, the costs are significantly greater. You only keep after-cost returns—which includes implicit and explicit costs.
Inefficient markets: An opportunity for managers?
Even though the market is a zero-sum game and inefficient markets have additional frictions, they may provide opportunities for managers to add value. It seems reasonable to expect that an active fund that performed well versus its peers in a less-efficient market would be more likely to perform well again in the future.
However, the figure below shows evidence that conventional wisdom can be wrong. We selected the top-quintile performers for the five years ended 12/31/2011, and then we looked at their performance in the subsequent five-year period. We found that these actively managed funds were just as likely to underperform their peers as they were to outperform.
Outperformance tends not to persist
In fact, among U.S. small-cap and emerging market equity funds, which tend to be less informationally efficient, the top performers during the first five-year period lagged in performance when compared with their peers in the next period. And surprisingly, Figure 1 tells us that the top quintile funds (as of the end of 2011) were more likely to fall to the bottom quintile or be merged or liquidated over the next five years than to remain in the top half.
A reason to question conventional wisdom
The conventional wisdom that active managers are more likely to outperform in less-efficient markets doesn’t always hold. With improvements in technology and rising competition, it’s becoming even more difficult for active managers to consistently outperform the market index, net of all costs. They’re no longer competing against potentially less-sophisticated retail investors—they’re competing against seasoned professionals, and their ability to find an informational edge is shrinking.
We believe investors can improve their odds of achieving success in active management by paying low costs for talented active fund managers and being patient (because even skilled managers will run into periods of underperformance). But there’s still something to be said for the edge you can get from knowing what your competitors don’t…which makes me think that maybe investors should start reconsidering conventional wisdom.
I’d like to thank Tom Paradise, Kunio Iwata, and Tim Clavin for their invaluable contributions to this blog post.
- All investing is subject to risk, including the possible loss of the money you invest.
- Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
 There is a belief in the industry that small-cap and emerging markets are easier segments of the market in which to outperform using active management.
 Sharpe, William, 1991. The Arithmetic of Active Management. The Financial Analysts Journal. 47:1: 7-9.
 Harbron, Garrett L., Daren R. Roberts, and James J. Rowley Jr., 2016. The case for low-cost index-fund investing, Valley Forge, Pa.: Vanguard.
 Beyond the competitive landscape, we must not ignore the increased frictional, operational, and market impact costs in many of these markets.
 For our thoughts on how to potentially succeed in active management, see “The keys to improving the odds of success in active management.” https://advisors.vanguard.com/VGApp/iip/site/advisor/researchcommentary/article/IWE_InvResKeysToImproveTheOdds.