If you know how to pick stocks, the world will beat a path to your door. Outperform the index for a year or two and you will be the subject of newspaper and magazine profiles.
Brokers and private investors will clamour for you to manage their money. People at cocktail parties will badger you for share tips.
The academic evidence, however, suggests that this is an overrated skill. The latest study by the Vanguard group shows that the bulk of returns comes, not from stock picking, but from humble asset allocation.
Deciding on a 70/30 equity/ bond split is the key to portfolio performance, not the ability to find the next Microsoft.
Vanguard analysed the performance of 420 US balanced mutual funds that operated in the period between 1962 and 2001. Balanced funds were defined as those with average long-run allocations to both bonds and equities of more than 20 per cent. Only funds with five years of return history were included. The actual performance of the funds was compared with a model portfolio - what the fund manager would have achieved if he or she had simply recreated the chosen asset allocation with index funds.
Vanguard found that, on average, more than 100 per cent of the long-term return of funds was attributable to asset allocation. In other words, the costs incurred in operating the fund were greater than the skills the managers displayed in either market timing or security selection.
Furthermore, the volatility of the model portfolio was only 86.6 per cent of the average fund. In other words, not only does a model portfolio achieve a higher return than most fund managers, it does so with lower risk.
Why are the stock selection and market timing skills of the average fund manager so poor? The obvious answer is that picking stocks and timing the market are extremely difficult. Efficient market theory may have been discredited in recent years, but it clearly contains a kernel of truth: that, at any given point, prices will reflect the available information.
A fund manager can beat the crowd, either by having better information or by taking a contrary view. But the former is hard to do legally, given the rules that all investors must be given equal access to relevant news.
Taking a contrary view can also be extremely risky in the short term, because it is likely to lead to underperformance. By the time the contrary view is proved right, the managers may have no money left to look after.
Worse still, all the costs involved in second-guessing the market eat into returns. Vanguard found that 7 per cent of the funds in its sample consistently outperformed the model portfolios, while 41 per cent consistently underperformed.
On average, the funds that regularly outperformed had lower expenses and lower portfolio turnover than the underperforming funds.
Indeed, the funds with the highest costs produced a performance that fell short of the model portfolio by around a third (e.g. the model earned 15 per cent a year and the high-cost funds 10 per cent). Cynics may say that we have heard this story many times, and it is not surprising to hear it again from Vanguard, a fund manager offering low-cost index funds.
But this is not simply a study about stock-pickers failing to beat the equity market. This survey looks at people who claim the expertise to manage a broad spread of assets.
Such managed funds may turn out to be highly popular over the next decade or two if, as many predict, overall returns are low and investors favour a higher bond component in their portfolios.
The evidence, however, goes beyond suggesting that investors may be wasting their time in trying to pick stocks. They may also be wasting their time in trying to pick active managers. Choosing the right portfolio mix (say 50 per cent equities, 40 per cent bonds and 10 per cent cash) is the really tricky bit. Once that is done, the chosen allocation can be achieved with index funds.
Or can it? It is easy enough to find an equity index fund at low cost. Bond index funds are less common. I could find no onshore UK unit trusts in this category, but the redoubtable Vanguard offers four Dublin-based open-ended bond index funds and four bond index mutual funds for domestic US investors.
Again, one has to be cautious about a company that discovers a problem and then happens to have a product that is the solution.
But Vanguard is a mutual company, owned by the investors in its funds, that is well-known for offering products at low cost. It is one of the most respectable names in the fund management industry.
That takes us back to choosing the right asset allocation. One rule of thumb is that the bond component should roughly equal the investor's age. So 25-year-olds should have 25 per cent of their portfolios in fixed income and 80-year-olds 80 per cent. Such an allocation would probably have looked rather conservative five years ago at the height of the bull market, but it looks more reasonable now.
Geographical diversification is another issue, even though the way bond and equity markets have tended to move in tandem in recent years shows that it can have only a limited impact.
Nevertheless, there are respectable arguments for, say, favouring euro bonds (sluggish economy, strengthening currency) over US Treasuries (improving economy, declining currency).
Much will clearly depend on an investor's attitude to risk. But the mere act of taking a decision and sticking to it, rebalancing the portfolio when necessary, should be a useful discipline.
Furthermore, adopting this structured portfolio will reduce transaction costs and management fees.
The approach will not eliminate risk altogether; one can still choose the wrong asset allocation. But at least it will reduce the risk of choosing a manager who fails to keep up with the benchmark.
Sources of Portfolio Performance, Vanguard Group, available from Brian.Mattes@Vanguard. com
- (Financial Times Service)
