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Tuesday, January 4, 2011
Many investors go the active management route because they believe indexing produces mediocre results. After all, in any period it is obvious that there are active funds, sectors, market timers, etc., that beat the market and beat the market by a lot. That will be true as well for 2010.
It follows, then, that the reward is huge for those who are able to beat the market or pick those who will beat the market - in the short run. If the investment strategy outperforms by 9%, it doesn't matter if fees and hidden costs are huge.
In my former life, I was an institutional investment manager. ,I managed funds for some of the largest pension funds in the country. Performance results were a big deal. Rankings with other managers who were competing for business were compiled, scrutinized and were a primary factor in gaining or losing business. The objective was to get performance in the upper quartile - the top 25%.
Quartile rankings were done for various periods: 1-year, 3-year, 5-year, 10-year, etc. As time went by, I noticed something interesting. We went through a period where we were consistently in the 2nd quartile - respectable, but not hitting the ball in the upper deck. What I noticed was that consistent 2nd quartile performance in the short run pushed us into the upper quartile over the long run.
Being in the second quartile meant you never went into a meeting and said we were number 18 out of a 100 managers for the last quarter or last year. Instead, you were more like number 38 or 42, etc. But for the longer term, the 5-year or 10-year results, you were able to say, in fact, we were number 18 or 15 out of 100.
How could this be? Studying the rankings over the long term, I found that many managers in the top quartile over the short term took risks or used a style that went out of favor in subsequent periods. They took positions and structured their portfolio radically different from the indices they were seeking to outperform. In some periods, they were very aggressive in timing the market. They went out of favor to such an extent that they performed in the bottom quartile - they went from hero to goat. Over the longer term, many ended up in the 3rd quartile.
For individuals, as well as for pension funds, the most important performance is over the longer term. Most individuals will be investing 35 - 40 years. By investing in low cost index funds, diversifying appropriately, and rebalancing according to a well-thought-out asset allocation, results will be in the second quartile ranking over most short-term periods. Over the longer term, this will have the best chance of reaching the top quartile where they want to be.