Knowledge Bank

If you haven’t yet done so, it’s well worth spending time studying the evidence about how investing really works. Here’s a brief selection of some of the most significant research underpinning our investment philosophy at Private Capital.

How efficient are the global financial markets?

The impression often given by the fund industry and the media is that securities are frequently either under-valued or over-valued and that shrewd investors can exploit such “mispricings” to their advantage. In fact, today’s markets are very efficient and beating the market return over long periods is extremely difficult: 

A brief history of market efficiency (Dimson & Mussavian)

History of the Efficient Market Hypothesis (Sewell)

How do actively managed funds perform?

The marketing departments of the big fund houses make active management seem like a no-brainer. But it’s been known since the 1970s that only a very small number of actively managed funds succeed in beating their benchmarks over the long term:

The loser’s game (Charles Ellis)

Challenge to judgement (Paul Samuelson)

One of the most comprehensive UK studies of active fund performance was conducted by a team led by Professor David Blake at Cass Business School in London:

New evidence on mutual fund performance (Blake, Caulfield & Ioannidis)

There’s a huge range of funds available to investors today. By the law of averages, you would expect some of them to outperform for short periods, and they do. The problem is that identifying a fund that will deliver persistent outperformance in the future is almost impossible:

On persistence in mutual fund performance (Carhart)

It’s not just UK fund managers who struggle to beat the market. S&P Dow Jones Indices keeps an on-going scorecard of active fund performance around the world, called SPIVA, and the results are remarkably consistent across different countries:

SPIVA Europe Scorecard (S&P Dow Jones Indices)

SPIVA US Scorecard (S&P Dow Jones Indices)

You can learn more about SPIVA and check on the latest data on fund performance here. A similar resource, with similar findings, is the Active/ Passive Barometer from Morningstar.

Do stockpicking and market timing add value?

There are two main ways in which active managers try to add value, namely stock selection and market timing, but the evidence clearly shows that they’re not very successful at either:

The courage of misguided convictions (Barber & Odean)

Likely gains from market timing (William Sharpe)

Determinants of portfolio performance (Brinson, Hood & Beebower)

How does overtrading impact on returns?

One of the reasons why active investing tends to extract value rather than add it is the cost entailed in buying and selling securities. The more your fund manager trades, the more you have to pay, and professional and individual investors alike are prone to trade too often:

The common stock investment performance of individual investors (Barber & Odean)

What makes index funds the logical choice?

The good news is that there’s a logical alternative to using active funds, and that’s to invest passively in low-cost index funds that track an entire market. It’s a mathematical certainty that the average passive investor will outperform the average active investor after costs:

The arithmetic of active management (Sharpe)

Why indexing works (Heaton, Polson & Witte)

Which factors drive investment returns?

While capturing market returns at low cost using market-weighted index funds is an excellent strategy, investors who want to try to beat the market can “tilt” their portfolio towards specific risk factors that have outperformed in the past, albeit with more volatility. Five such factors have been identified by the American academics Eugene Fama and and Kenneth French:

Characteristics, covariances and average returns: 1929-1997 (Davis, Fama & French)

A five-factor asset pricing model (Fama & French)

What are the benefits of diversification?

It seems common sense that investors should avoid putting all their eggs in one basket, but the benefits of diversification are also confirmed by several studies. It was another US-based academic, Harry Markowitz, who found that combining asset classes whose returns are imperfectly correlated can help to reduce risk without giving up return:

Portfolio selection (Markowitz)

What do the UK regulators make of the fund industry?

Campaigners have complained for many years about the poor value provided by the fund industry, and particularly about the lack of transparency around fees, charges and the reporting of fund performance. Thankfully the Financial Conduct Authority now appears to have taken notice. Both the interim and final reports of its study into competition in asset management make very interesting reading:

Asset Management Market Study, interim report (FCA)

Asset Management Market Study, final report (FCA)

As a result of its market study, the FCA asked the Competition & Markets Authority to investigate the investment consultancy sector in particular. Subsequent analysis by the CMA has found no evidence that investment products recommended by consultants have outperformed, net of costs:

Asset manager product recommendations (CMA)