Mediocrity Strikes Again

It’s true for stocks, it’s true for bonds—yes, it’s even true for hedge funds. As The Economist reminds, delivering market-beating performance over time relative to a conventional asset mix is tough, and the financial wizards in the land of hedge funds aren’t immune. “A simple-minded investment portfolio—60% of it in shares and the rest in sovereign bonds—has delivered returns of more than 90% over the past decade, compared with a meagre 17% after fees for hedge funds,” the magazine reports. Sound familiar?

It’s now widely accepted, or at least widely known, that zero-sum math rules within a given asset pool. As Bill Sharpe explained, “There’s no escaping “Arithmetic of Active Management.” Savvy marketing hype doesn’t change this fact. Nor does charging two and twenty. Like mortality and taxes, financial gravity catches up with all of us (or at least most of us) in time. That’s not to say that you can’t find big winners, or big losers. But the majority of performance results relative to an appropriate (i.e., objective) benchmark has a habit of dispensing unimpressive track records as a general rule.
I say “unimpressive” because it’s no great feat to earn average returns. The main question is how much you pay for mediocrity. This is no trivial issue. In fact, after you factor in fees, trading expenses, and taxes, representative benchmarks for a particular market or even trading strategy have a tendency to dispense above-average returns. No wonder that indexing is competitive next to a broad definition of active strategies intent on delivering positive alpha.
Even passive asset allocation that holds the major asset classes holds up rather impressively against the crowd of professionals who collectively promise to do better than average (and charge a fee in advance that assumes no less). Comparing the Global Market Index (GMI), a passively weighted mix of all the major asset classes, against 1,200-plus mutual funds with multi-asset-class strategies over the past decade tells the story. For instance, here’s how the returns stack up through a recent 10-year period, as I reported back in October:

GMI ended up near the 75th percentile for performance. That’s probably high relative to what you should expect for the next 10 years. But average to above-average results are good bet, in part because you can replicate GMI for less than 50 basis points with ETFs. By contrast, the active strategies depicted in the chart above nip you for two, three, and even four times as much. Over time, that’s the equivalent of trying to run a race with a couple of bricks tied to your feet.
These types of studies are now a staple in financial research. The lesson for most folks is that broad diversification across asset classes, and periodic rebalancing of those assets, will capture average to above-average returns on a fairly reliable basis through time. The flip side of this lesson is that trying too hard in money management boosts the odds of ending up with high-priced mediocrity, or worse.
Granted, a relative few will beat the odds. Predictably, this is where the crowd focuses. The dirty little secret, however, is that the upper decile or quartile of performers is often a fluctuating mix of names. By contrast, a representative benchmark is a dependably average to above-average performer. This empirical fact, however, is the equivalent of a wet rag when it comes to popularity contests among investment strategies. Considering the returns that most folks end up with, however, that’s a costly oversight.