A winning horse doesn't repeat?

The cost differential between active and passive funds is a parachute that's hard to drag over the long term.

Much is heard about forecasts and estimates of possible winners, or where it would be advisable to overweight an investment portfolio to try to maximize its returns. But if we look at the performance of active funds (those that seek to differentiate themselves from the market return by betting on certain sectors or companies) during 2022, 45% of U.S. Large Cap funds beat the S&P 500's returns, while 55% failed to gain any advantage from the active strategy.

Part of this is explained by costs. In horse racing, if we see a horse running with a parachute tied to it, we probably won't bet on it since it's at a clear disadvantage. On average, active funds in the U.S.

charge 0.68%, while passive indices that replicate the S&P 500 charge from 0.03%. The cost differential is a parachute that's hard to drag over the long term.

Returning to returns, it would seem there is an almost 50% probability of beating the market vs. investing in an index such as the S&P 500. However, if we extend the period analyzed, we can see that an active strategy tends not to be consistent over time. Looking back three years, 14% of funds managed to beat the index, while over 10 years only 10% did.

Now, it's reasonable to ask whether it isn't a good strategy to simply invest in those funds that have beaten their benchmark over a prolonged period. If we take the universe of U.S. Large Cap funds that beat the index for 3 years between 2017 and 2020 (SPIVA analysis, S&P Dow Jones Indices), only 21% of these stayed above the index during 2021, while none managed to remain in this category during 2022. In other words, none of the “winning” funds was persistent over the medium term.

It would seem it's quite feasible to beat the market in the short term, due to sector, regional, category biases or simply luck. But for this to be called a skill and be useful for the average investor, persistence in returns has to be identified, which, in light of the above, is not possible.

Therefore, it can be very tempting to follow the “winners,” but over the long term, diversifying, keeping costs low and betting on the market will deliver better results.

Nicolás Urcelay

Wealth Management Associate at Abaqus

This column was originally published in El Mercurio Inversiones [LINK] on 14-02-2023