Picking apart the idea of a stock-picker’s market

The financial services industry views stock-picking as a credible endeavour that adds value by knowing when it’s best to get in and out of certain securities or sectors. Yet, stock-picking adds no value in aggregate and subtracts value once fees and taxes are included. That’s not me talking; that’s a combination of logic plus evidence from a Nobel laureate.

The logic is simple: the extent to which one side of a trade wins is equal to the extent to which the counterparty loses. The proposition is zero sum before costs, because the two sides cancel each other out.

The evidence comes from a paper written by William F. Sharpe more than 30 years ago. In “The Arithmetic of Active Management,” Sharpe showed that the average actively invested dollar must underperform the average passively managed dollar. This is true of all asset classes over all time horizons and in all market conditions.

In other words, because traders are on opposite sides of the same trade, taken together, the pair is neither better nor worse off than a passive investor who simply holds the shares. And that’s before considering fees and taxes, which are consistently higher for active strategies.

So, trading does not create wealth; it merely redistributes it. There is never a time when it is better or worse to trade stocks. The odds never change. It’s a wash.

Despite the evidence, the industry talks up stock winners while remaining silent on the losing counterparties. If the audience (including advisors) can be convinced that it is both possible and rational to reliably pick stocks, then the desired behaviour follows, and profits are increased.

For decades, industry players have made claims that “we’re entering a stock-picker’s market” — as if such a thing existed. This is akin to saying we are entering a lottery number-picker’s market. In reality, the odds never change.

And, while the industry is quick to opine that we are entering a stock-picker’s market, it almost never points out when we are leaving one. Why is that? If a stock-picker’s market existed, wouldn’t there be products or services that pick stocks while in a stock-picker’s market and use indexing when not in a stock-picker’s market?

Judging by their behaviour, it seems that a large majority of financial advisors believe active management will prove successful over long time horizons when the evidence makes it clear that is not the case. Currently in Canada, the ratio of assets under management in active funds versus passive ones is about 6:1 (based on data from the Canadian ETF Association). Those numbers should likely be reversed.

Twice a year and in all major countries, Standard and Poor’s releases index vs. active (SPIVA) reports that tabulate the percentage of active funds that beat their passive benchmarks over one-, three-, five- and 10-year time horizons. In almost all asset classes and jurisdictions over almost all time horizons, fewer than half the active funds manage to beat their benchmarks. And the likelihood of beating the benchmark consistently goes down as the time horizons are extended.

Nonetheless, advisors tell their clients to take a long-term perspective when making investment decisions. How do they justify their recommendations in light of the evidence? This misguided mindset has been allowed to persist for too long.

To begin, we need to face the evidence. Advisor education should make it clear that active management is unlikely to yield positive results over time. Note that “unlikely” is not the same as “impossible.”

More explicit packaging would also help. Fund Facts that investors receive should come with a clear explanation of how active funds tend to underperform their benchmarks over time.

We should also make sure that, from the beginning, advisors are trained with the best information. The long-run solution rests with making sure new advisors don’t repeat the mistakes of the previous generation.

John De Goey is a portfolio manager with Designed Securities Ltd. He can be reached at jdegoey@designedsecurities.ca.

John De Goey

Planning and Advice