Three mistakes that can keep you from beating the market
19 June 2017 | Topical insights
The era of active investing is coming to an end, or so headlines will have you believe.
In recent years, subpar performance by actively managed fund products – equity and bond funds alike – has led some investors in the United Kingdom and other countries to part ways with active investing, preferring indexed portfolios that represent the market rather than those that attempt to beat it.
Vanguard Senior Investment Strategist Daniel Wallick has a more optimistic perspective.
"Not only is it possible to beat the market," he said, "but it could be a matter of following a few simple rules to increase your chances of long-term active investing success."
Specifically, Mr Wallick cites three common pitfalls that investors should avoid:
- Performance chasing.
- Paying too much for investments.
- Expecting a fund to beat the market all the time.
Mistake 1: Chasing performance
It's tempting to look at past performance when shopping for a new fund. But if you're buying or selling a fund based solely on what happened in the past, you could be setting yourself up for disappointment.
Because luck or undue risk-taking can play a significant role in how well a fund does, past performance should be only one of several factors in picking a fund.
At Vanguard, the team that hires managers to oversee active funds looks closely at the people, processes and philosophy that drive investment decisions and, ultimately, a fund's performance. Here's a snapshot of the questions our Manager Search and Oversight Group asks:
|Firm||Is there a culture of investment excellence and stewardship? Is the firm financially stable and viable?|
|People||Are the key investors experienced, talented and passionate? Do they have the courage to have a different view but the humility to correct a mistake?|
|Philosophy||Does the firm have a clear philosophy on how it seeks to add value that is universally shared by its investment personnel?|
|Process||Does the firm have a competitive advantage enabling it to execute its process well and consistently over time? Can the process be effectively implemented for the assets to be managed?|
|Portfolio||Do the firm's historical portfolio holdings and characteristics align with its philosophy and process?|
|Performance||Are the firm's drivers of historical performance logical? Are they sustainable over the long term?|
Mistake 2: Paying too much for investments
Good performance is worth paying for – just not too much.
While high-cost funds that beat the market exist, Vanguard's research found that the least expensive active funds had better odds of beating their benchmarks than the most expensive funds. That's because lower costs allow one to keep a greater portion of an investment's return.
For example, a hypothetical higher-cost fund with an ongoing charges fee (OCF) of 1.5% compared with a lower-cost fund that charges 0.3% would need to outperform by a little more than 1.2% before it catches up to the lower-cost fund, assuming both funds earn the same returns.
In other words, paying less can increase an investor's chances of active investing success.
Mistake 3: Expecting a fund to beat the market all the time
Investors don't like losses, especially if they expect to outperform the market. But underperformance is inevitable. In fact, stretches of underperformance are common among even the best managers.
To demonstrate this, we looked at the performance of equity funds in the United Kingdom during two separate, sequential, non-overlapping five-year periods. First, we ranked the funds by performance quintile in the first five-year period, with the top 20% of funds going into the first quintile, the second 20% into the second quintile, and so on. Then we sorted those funds according to their performance in the second five-year period. (To the second five-year period, we added a sixth category: funds that were either liquidated or merged during that period.)
We then compared the results. If managers were able to provide consistently high performance, we would expect to see the majority of first-quintile funds remaining in the first quintile. The table below, however, shows that a majority of active managers failed to outperform consistently.
Actively managed UK equity funds failed to show consistent outperformance
Past performance is not a reliable indicator of future results.
Notes: The far left column ranks all active equity funds available in the UK based on their excess returns relative to their stated benchmark during the five-year period as at the date listed. The remaining columns show how funds in each quintile performed over the next five years. Sources: Vanguard and Morningstar, Inc.
While it might be tempting to abandon a fund during a rough patch, if you can hold tight, you can enjoy the potential rewards if and when a fund's performance rebounds. For such a reason, having appropriate expectations and maintaining patience with high-quality managers who faithfully follow a process is critical to realising long-term outperformance.
Vanguard's active pillars: Talent, cost and patience
There are no shortcuts to identifying the right managers to invest with, but avoiding these three common mistakes can get you closer to reaping the rewards of long-term active investing success.
Our belief is that investing in low-cost funds combined with a rigorous and thoughtful manager-selection process to identify top talent can help improve your odds of success in active investing. Finally, having the patience to endure inevitable periods of underperformance through time is critical to realising the long-term success of outperformance.
This article is directed at professional investors and should not be distributed to, or relied upon by, retail investors. This article is designed for use by, and is directed only at, persons resident in the UK.
This article was produced by The Vanguard Group, Inc. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.
Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
The opinions expressed in this article are those of the individual authors and may not be representative of The Vanguard Group, Inc.
Issued by Vanguard Asset Management, Ltd, which is authorised and regulated in the UK by the Financial Conduct Authority.