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Has the Stock Market Changed, or Have Its Investors?

The answer seems to be both.

John Rekenthaler, 11/14/2013

The Question
A couple of months back, Julie Segal penned a long article for Institutional Investorcalled "Beating the Market Has Become Nearly Impossible." The title states the thesis: The stock market has changed. Back in the day, a skilled investment manager stood a fair chance of beating the stock market. (Segal's article mostly discusses U.S. stocks, but it sometimes veers into other arenas. For this discussion, we will consider the U.S. stock market only.) However, those days are long gone. Today, the competition has become too difficult, such that almost nobody can manage the task.

That beating the market today is difficult will surprise nobody, not even mutual fund shareholders, who as far as institutional investors are concerned, rank near tadpoles and pond snails. Whereas pricey actively managed funds once dominated the stock-fund sales charts, these days the top-selling funds are either outright indexers, or low-cost, institutional shares from a mere handful of managers. 

The question: Have investors changed their habits because the markets are different? Or have the markets remained constant, but investors have revised their views?

The answer very much matters. If the U.S. stock market once offered good opportunities for savvy investment managers, but not any longer, then perhaps other, less-popular marketplaces remain to be exploited. By this logic, active management is unduly criticized. It struggles with the evolutionarily advanced U.S. stock market, but in less mature areas, active managers will flourish. They, rather than an index fund, should be the informed investor's first choice.

If, on the other hand, conditions in the U.S. stock market have remained largely unchanged over the past several decades, then the argument for active management in other spheres weakens. The U.S. stock market is by far the best-measured investment space. It is because we know U.S. stocks so well that we doubt the power of active managers. Thus, by this logic, if we understood other marketplaces equally well, we would doubt them just as much. We would likely index rather than buy an active fund.

Segal's Case
Segal's article, as we have seen, posits that it is the markets that have changed. 

She writes that U.S. stock managers once could pluck "low-hanging fruit," but now they must clamber up the tree. This line of thought is not convincing. What easy fruit was it that managers once plucked? The article cites domestic stock-fund managers buying foreign stocks in the 1980s and early 1990s. That was not low-hanging fruit; it was an investment gamble that had a 50% chance of landing tails rather than heads. Those managers did not contribute alpha through stock selection. They bet on another asset class. It was a bet with a sample size of one. 

Another argument is that the stock market became more efficient as it has became more professionalized. Over the past 50 years, institutions have replaced tadpoles and pond snails individuals as the U.S. stock market's dominant trader. The Chartered Financial Analyst program has sprung into existence. Markets have become globalized, with huge foreign buyers. These sophisticated new players pounce on inefficiencies and quickly arbitrage them away.

is vice president of research for Morningstar.

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