By: Julio Cacho, PhD
Nobel Prize winning economist William Sharpe argues that active managers will underperform the market on average for the simple reason that active funds have higher costs and taxes associated with them. Sharpe also developed a theory (See here) that explains why broad-based index funds should outperform active funds based on the idea that markets are efficient in the long-run and people, on average, are rational and risk adverse.
That said, we believe that markets are not perfectly efficient in the short-run, and people may not act rationally due to behavioral biases, so this might create price dislocations. However, in the long-run (25 plus years) competition and rationality provoke the prices to converge to their fundamental value.
Some active managers will argue that they can take advantage of the dislocations and beat the market. Unquestionably, some will and a few are going to outperform for a period because of either luck or skill. But it is unlikely to be persistent, and you may have to time when to use that active fund. In addition, technology has clearly improved the flow of information, causing market participants to react faster and is likely making markets even more efficient.
In summary, I propose a simple question to you. Given all the empirical and theoretical evidence that most active funds will not outperform the market, the high likelihood that you may end up much worse than the market, and the fierce competition to outperform, would you still take the risk of hiring an investment manager to beat the market?
But don’t take our word for it. Take a look at this short video and listen straight from the mouths of some of the greatest investors and prestigious academics who have devoted most of their professional careers trying to find the truth behind this.