Market beaters may be just lucky

It all seems so easy: smart investment managers rise to the top. All an investor has to do is identify one of the geniuses who runs a portfolio that has been successful for a long period of time. By hitching his fortunes to that of the star investment manager, the investor will have a better chance of beating the stock market and reaping big rewards.

The proof, of course, is out there. Certain mutual fund managers have beaten market indexes relevant to their portfolios for many years running. They obviously have a leg up on everyone else, or why would they have done so well?

There is a big hole in this type of argument: no valid statistical proof exists to show that someone who has beaten the market for a period of time will continue to do so in the future. In fact, no statistical proof exists to validate the long winning streaks enjoyed by some investment managers. The incidence of a few investment managers who possess long winning streaks can be explained more easily—they may be just lucky.

Take Bill Miller, the currently famous manager of Legg Mason Value Trust. He is the only manager of a mutual fund that invests in large U.S. stocks who has beaten the Standard & Poor’s 500 Index for 11 years running. Sounds impressive, doesn’t it? For the 10 years ended on April 30, his fund returned an average of 17.26% per year, which was five percentage points better than the S&P 500. Even more important, the fund’s performance was better than the S&P 500 Index in each of the 11 years through 2001.

The problem with feeling good about that record is that it could easily be due to chance. Each year there are winners and losers on Wall Street. If results are random, someone will come out on top after a long period of time. For example, consider the 5,000 or so mutual fund managers who were in business 11 years ago when Miller’s streak began. Assume that each year half of those managers beat the market. After one year, there would have been 2,500 fund managers with bragging rights. After the second year, 1,250. In seven years, the stable of winning managers would have been reduced to 39. And, after 11 years of competition, just two managers would have emerged as winners.

It is interesting that in the real world only one manager – Miller – has that distinction. That may be due to the handicap that active portfolio managers face – the expenses of operating their portfolios make it even harder to beat the market averages. Miller’s fund, for instance, currently has an expense ratio of 1.69%. That means in order to give investors a net gain of 10% in one year, Miller has to earn a gross return of 11.69%. “Recovering these costs is surprisingly difficult in a market dominated by professional investors who are very competitive, extraordinarily well informed, and continuously active,” wrote Charles D. Ellis in “Winning the Loser’s Game” (McGraw Hill, 2002).

Indeed, Miller is having a tougher time beating the S&P 500 by a respectable margin. From 1996 through 1999 he beat it by a wide margin. His best year was 1998, when he bested the market by almost 20 percentage points. In 2000 and 2001, he beat the market by small margins but lost money. His fund declined by 7% in 2000 and 9% in 2001. So far this year the fund has lost almost 5%.