Why Active Investing is a Negative Sum Game

In this article well known academics Eugene Fama and Kenneth French reflect on Nobel Laureate William F Sharpe's 1991 article on the arithmetic of active fund management. This has already been discussed on this blog and you can see a copy of that article here

Cutting through the slightly complex jargon that is used by Fama and French,the essence of what they are saying is that the combined portfolios all active investors have the same weighting in shares as the market as a whole. This means that the combined portfolios can only perform the same as the market, less their costs. It also means that the only way in which an active investor can outperform the market is to do so at the expense of other active investors.

In contrast, passive investors also all hold the same weighting in shares as the market as a whole. This means that their portfolios should perform the same as the market, less their costs. However, as their costs are less than those of active investors, passive investors as a group must outperform active investors.

This article does not seek to deny that some active investors do outperform the market. It is just that their gains have been made at the expense of other equally clever active investors. Other research has shown that winners tend not to repeat and that on the whole, they do not tend to remain winners for very long.

When considering whether to invest actively or passively you have to answer the question 'Are you feeling lucky?' For active investors the answer must be 'Yes' - in the face of the evidence. For passive investors the answer is 'No - but at least I will be assured of returns that essentially replicate the market less my costs which are substantially less than for active portfolios'.

From a financial planning point of view, investing should not be seen as a game. Investments are not an end in themselves. Instead they are the means by which individuals fund for the serious financial goals, which they need to achieve in order to lead the future lifestyles that they desire. Speculation on which fund manager is likely to provide better returns than another, in the face of evidence that this is likely to be an unsuccessful strategy, has no place in this process.

Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you

Importance of Costs

In this article Morningstar have coommented on the importance of costs on fund performance. This is a subject about which I have made a number of posts (see: Hidden Cost of Investment posted here in March 2008.

Investors should be wary of excessive costs. Not just the TER (which is the total published expenses of the fund) but also the effect of portfolio turnover as this is not disclosed in a way that is easy for most investors to understand and can act as a significant break on performance.


Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you

Government Restricts Higher Rate Relief on Pension Contributions

In today's Budget the Chancellor has restricted higher rate tax relief on employee contributions to pensions where the employee earns £150,000 or more and makes annual contributions of £20,000 or more.
For further details see this

Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you

Can investors trust what they don't understand?

In this video Tim Haywood, chief executive of Augustus Asset Managers argues that investors should place the same level of trust in fund managers as they do in manufacturers of high performance cars. In essence, do not try to understand what goes on under the bonnet.

In general derivative based funds, using options and futures and other complex financial instruments are difficult to understand for most investors and it is arguable that even the fund managers do not exactly know what levels of risk they are entering into. In addition, many tend to be based in offshore locations and lack proper transparency.

What can we learn from Past Financial Turnoil

This presentation by Inmoo Lee of Dimensional Fund Advisers explores previous financial crises and tries to draw out what we can learn from them in terms of our expectations going forward.

The Arithmetic of Active Management

In the video featured below, Professor Kenneth French mentioned the paper written by Nobel Laureate Economist William F Sharpe. Well here it is.

This type of information needs to be seen in a completely different light to what those of us who are more enlightened call financial porn because it is the informed view of a very highly rated and acclaimed academic. Unlike fund management companies who pump out marketing material designed to entice unwitting investors to part from their money William F Sharpe and others like him have spent decades trying to get to the truth. They have no axe to grind.

The question you have to ask your self is, Do you want to be one of the (as William F Sharpe puts it) "individual investors ... foolish enough to pay the added costs of the institutions' active management via inferior performance". Of course there is also the famous Dirty Harry saying "What you want to ask yourself is ... Are You Feeling Lucky?"

For more information on William F Sharpe see this

Stock Picking v Index Investing

I have just found this extremely interesting video link which shows Professor Kenneth French talking about Stock Picking and Index Investing. He explains, far better than I ever could, how stock picking is essentially a fools errand ... but a very necessary one which enables those of us with more sense to take a cheap ride on the increased market efficiency which their zero sum strategies create. He also makes some very interesting comments about Hedge Funds.