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Why Are Fund Managers So Awful at Their Job?

The service industry will always exist for one reason: There's a group of people out there with a mastery of a skill or craft for which the general public has little clue.

For example, if my vehicle's engine begins to sputter, I'm going to take it to a mechanic, because that individual is skilled in diagnosing and fixing automobiles, far more so than myself. Likewise, if I have a persistent fever, I'm headed to my doctor, because the doctor will know the best method of diagnosing what I have and how to treat it.

The same can be said for our money. While some investors feel perfectly comfortable being the purveyors of their own financial destiny, many turn to professional money managers to grow their wealth over time. Since these folks have been around the investment landscape for years or possibly decades, the assumption is that they know the ins and outs of how to make their clients rich over time.

Then again, the data tells a different story.

Image source: Getty Images.

Professional money managers are terrible at their job

Since 2001, S&P Dow Jones Indeces has released its annual SPIVA U.S. Scorecard report, which examines the performance of fund managers relative to their most closely linked benchmark index. Whereas most funds are often compared to the performance of the broad-based S&P 500 (SNPINDEX: ^GSPC), this doesn't always equate to an accurate comparison, especially if it's a small-cap growth fund or say a real estate fund. The SPIVA U.S. Scorecard adjusts for this, and other factors, to give investors an encompassing look at how the professional fund managers are really performing over one-, three-, five-, 10-, and 15-year time frames, relative to their benchmark.

So, how does Wall Street stack up? Well, let's just say a blind coin flip might give you a statistically better chance of beating benchmark indexes.

Over a one-year clip, things aren't a total loss, with 68.83% of all domestic funds underperforming their respective benchmark index. Of the 17 major U.S. fund categories, a majority of money managers in only three areas -- mid-cap funds, mid-cap growth, and large-cap value -- outperformed their respective benchmark index in 2018.

But things get brutally bad when the performance of fund managers is examined over the long-term. Over the past 15 years, a whopping 88.97% of domestic funds have underperformed their respective benchmarks, with the "best" performance coming from fund managers in the large-cap value arena, where a "mere" 79.33% have lagged their benchmark. Meanwhile, 98.17% of small-cap growth funds, 97.44% of small-cap core funds, and 96.73% of all small-cap funds (notice a trend?) trailed their respective benchmarks.

Image source: Getty Images.

Why are fund managers so awful at their job?

Suffice it to say that professional money managers are really, really bad at what they do, at least in terms of beating the market, which is typically what their clients hire them to do.

How, you ask, can someone whose sole purpose is to outpace a simple index be so bad at his or her job? I'd say it breaks down to three factors.

1. Fund managers are too focused on the short term

First, it could be rightly argued that fund managers are trying to do too much to beat their respective index. More specifically, they're focused on the short term when they should really have their eyes on the horizon.

For context, Michael Laske, a research manager at investment company Morningstar, found that the average turnover ratio for domestic stock funds through Feb. 28, 2019, was 63%. The "turnover ratio" represents the portfolio churn rate, or the percentage of holdings that have been changed over a defined period. In this instance, Laske found that pretty much five out of every eight stocks in a domestic fund were being changed out every year. That suggests some very short-term and emotionally oriented thinking on the part of money managers.

The problem is that it's impossible to predict with any long-term consistency what's going to influence the stock market in the short term. According to annually released research from J.P. Morgan Asset Management that emphasizes the importance of staying invested in volatile markets, a majority of the S&P 500's best trading days often occur within two weeks of its worst trading days over a trailing 20-year period. Timing those days would prove to be an impossible task. Yet based on 63% average domestic fund turnover over the past year, it would appear that's exactly what money managers are trying to do.

Image source: Getty Images.

2. Buy bias and the need to be liked is holding money managers back

Another inherent flaw with professional money managers is they struggle to recognize a bad investment. I like to refer to this as Wall Street's "buy bias."

Regardless of whether you're a professional money manager or a Wall Street analyst, you want to be liked by your colleagues in the business, as well as the companies you may cover or invest in. Of course, that can change when an analyst or money manager speaks negatively about a business and/or its management team. If you go out on a limb and are correct, you're hailed as an investing oracle. Then again, if you're wrong, you're a fear monger that may have burned bridges with the companies you cover or invest in.

Back in December 2016, the Economist examined all equity ratings for companies in the S&P 500. What the publication found was that 49% of all ratings were the equivalent of buy or outperform, with another 45% being some equivalent of hold or neutral. A mere 6% of all S&P 500 stock ratings were a sell or underperform. For context, about half of all S&P 500 stocks underperformed the index in 2016, the year the Economist conducted its study.

Historically, we know that around half of all stocks (not to be confused with S&P 500 companies) are going to lose value. Thus, fund managers are doing no one any favors by allowing their buy bias to influence their investing decisions.

Image source: Getty Images.

3. There's no true accountability

A final issue that unfortunately flies under the radar more times than not is that fund managers have little true accountability.

I know what you're probably thinking, and yes, a fund's performance is tracked based on its return over one year, three years, and so on. But as noted earlier, it's not often that targeted funds are compared on an apples-to-apples basis to a proper benchmark. Fund managers may opt to massage their returns by comparing them to "an orange" to make them look better, which is a disservice to consumers looking for a place to invest their money.

Perhaps the bigger problem is there's little accountability if fund managers are wrong. Since fund managers generate their own income from upfront fees, the performance of their portfolio often has little long-term impact on their wallets. In other words, if a fund manager underperforms the market, the only who walks away as a loser tends to be the investor who put money into the fund, and not the fund manager.

Ultimately, if this collection of data doesn't make you want to learn the ropes of investing for yourself, then I'm not sure what will.

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