FINANCIAL TOOL
Active Investing
Even though market efficiency is the normal state of the stock market, evidence also shows that there are rare moments when markets stray from efficiency.
That’s what active managers attempt to identify and use to their advantage.
They don’t simply stick to the benchmark. They actively overweight and underweight certain stocks, industries, stock styles and/or asset classes in order to outsmart the broader market.
These inefficiencies in the stock market develop particularly in times of extreme greed and extreme fear.
These moments may not come around for many years, but if an active fund manager can identify these moments with decent precision, this can make up for the years of underperformance that they are bound to experience from time to time.
It’s a rare breed that can take advantage of these moments in history, though. And it’s even more difficult to tell which ones were lucky and which ones were geniuses.
That’s why I like to do at least three things when analyzing an active fund.
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- I look at the average 10-year return history, if available.
- I look at the rolling 5-year average for as far back as I can track the annual returns. For example, 2015-2019, followed by 2016-2020, and so on.
- I compare these numbers with the benchmark.
Someone might get lucky early on, which causes their entire 10+ year return to look amazing. That’s why it’s important to look at the 5-year average rolling returns as well, to see if they are able to replicate some outperformance of the market more often than not. We want to see that happening at least 50% of the time.
And we want to see the magnitude of the underperformance years not so large as to give up all the positive outperformance they’ve experienced in the outperforming years.
Sorting through the skilled, the unskilled, the lucky and the unlucky is not easy, but simply doing these three things can offer valuable insight.