Has the Stock Market Changed, or Have Its Investors?

The Question
A couple of months back, Julie Segal penned a long article for Institutional Investor called "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 become 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.

Maybe. The claim does sound sensible. But it's more assertion than fact. It also fails an initial sanity check. When institutions have most ruled the roost, during the past 15 years, the U.S. has had its highest stock prices in history, then three consecutive years of stock declines, a resurgence, then the worst calendar-year loss in 71 years, and then once again a soaring bull market. This is efficiency? 

If institutions have improved matters, it would seem to be at the level of security selection, rather than in evaluating the worth of an asset class. By this logic, institutions are better than a collection of individuals at pricing securities within an asset class, which thwarts professional managers who try to find mispricings. Institutions in contrast are not better than individuals at determining the worth of asset classes, which would seem to present an opening for active managers, but active managers can't do the task either. The opportunity goes unexploited. 

At least I think that's where the "institutions-bring-better-pricing" argument needs to go. 

The final--and in my mind--strongest argument by Segal is the Ted Williams argument. For those readers unfamiliar with baseball analysis, the Ted Williams argument addresses why in its early years, major league baseball had so many players hit .400 or better for a season, but since Ted Williams accomplished the feat in 1941 nobody has since hit the mark. It is not that overall batting averages have declined. Rather, it is the superstar who has disappeared.

The reason advanced by baseball analysts is that over time, baseball became more efficient. Early on, there were relatively few high-quality players--only a few savvy institutions, to return to the topic of investing. These players feasted on the league's weaklings and posted superstar batting averages. As major league baseball matured, however, the quality of the rank-and-file improved (individual tadpoles were replaced by respectable institutions), so that the superstars faced stronger daily challenges. Their numbers subsided. They became only stars.

That claim looks to be correct about baseball. The standard deviation of batting averages has indeed come down over the years, along with the standard deviation of most other major statistics. The gap between the best and worst players is smaller. The baseball market, one might say--and Segal's article did--has become institutionalized.

Has the same occurred with investments? Probably so. Segal cites an article by Professors Barras, Scaillet, and Wermers that shows the number of "skilled" U.S. stock mutual fund managers declining sharply from the mid-1990s until now. The professors determine skill by subjecting funds to the well-respected Fama-French-Carhart four-factor model, which attempts to isolate alpha from beta. The authors also generate additional statistical tests. I believe their results. I believe that U.S.stock-fund managers did have it easier two or three decades ago.

Caveats
It's a good paper, but there may be missing factors that explain the funds' behavior. Also, even if active U.S. stock funds have a harder time today than they did in 1990, the difference does not seem great. After all, by 1990 index stock funds had already captured much of the institutional marketplace, and Vanguard was starting to become a major mutual fund player. Running actively managed U.S. stock funds wasn't shooting fish in a barrel back then, either.

As hedge fund manager Cliff Asness states in the article, "When I hear some market strategist say, 'It's hard to forecast the market right now,' I always want to scream, 'When was it easy?'" Asness adds, "Predicting the future is harder than misremembering the past." 

In summary
For me, the answer lies halfway between the two ends. By no means has all the change come from the stock market. For their part, investors have dramatically altered how they measure and view active managers. However, it does seem that the distance between the best and worst investment managers, as with baseball hitters, is narrowing.

If this view is correct, then the upshot is that active managers may indeed be the best option in less-traveled investment areas--but they will need to be kept under close watch. Almost never will they be worth paying above-average expenses. Cost control is the number one investor task, with manager identification being an important secondary job, but nonetheless secondary. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.