Why the pro’s often do not beat the market index.

PaulRen's picture
Book Review

Why pro's often do not beat the market index. Money Managers in every investment style underperform the market index. So exactly says the big updated book on that subject. Find out here why that is.

While the experts are puzzled we are not. A review of why we have the advantage and what the big books just won't tell you.

It has long come to all our attention here that there is a huge size dis-advantage when it comes to investing in emerging stock markets, like Thailand.

Many things in business get better or cheaper as you get bigger; economies of scale, purchasing power, better information etc….but this is clearly not so in the stock fund management business, so it seems.

I have here shown again and again how the smaller capitalized Thai shares have, by far overall, outperformed the SET index and this every year since 1997. We have also observed here first hand, that individual investors with say a few million Baht, have a (seemingly) huge advantage over a fund with millions of Dollars under management. How can this be? Why does no author or business magazine tell us about this? Or at least explore the issue of "size is no prize", at least when it comes to emerging market fund management.

The flexibility of getting in and out of stocks quickly, the ability to chose stocks based on low valuation -not liquidity, the ability to avoid large cap stocks based on poorer investment merits…yes, these features have all proven to be a huge advantage to the prudent individual. Together this beats even the seemingly information advantaged fund managers.

Consider some important up to date writings on this important subject from the World's top Investment Finance book called, "Investment Valuation", 2002, Second Edition, 992 Pages *

Here are their conclusion:

"Market Inefficiencies and Money Manager Performance:

"The evidence on markets is contradictory. On the one hand, there seem to be numerous patterns in stock prices -stock prices reverse course in the long term and returns are higher in January- and evidence of market anomalies-small market cap firms with low p/e and price to book ratio's seem to handily beat the market. On the other hand, there seems to be little evidence of money managers being able to exploit these findings to beat the market.

"There are a number of possible explanations. The most benign one is that the efficiencies show up mostly in hypothetical studies and that the transaction cost and execution problems associate with converting these inefficiencies into portfolio's overwhelm the excess returns.

"A second possible explanation is that the studies generally look at the long term; many are over 20 to 50 years. Over the shorter periods, there is substantially more uncertainty about whether small stocks will outperform large stocks and whether buying losers will generate excess returns. There are no investment strategies that are sure bests for the short periods.

"Pradhuman (2000)illustrates this phenomenon by noting that small cap stocks have underperformed large cap stocks in roughly one out of every four years in the past 50 years.

"Bernstein (1998) notes that while value investing (buying low PE and low price to book value stocks) may earn excess returns over long periods, growth investing has outperformed value investing over many five year periods during the past three decade3s.

"A third explanation is that portfolio managers do not consistently follow any one strategy but jump from one strategy to another, both increasing their expenses and reducing the likelihood that the strategy can generate excess returns in the long term."

*By Finance Professor Aswath Damodaran, www.damodaran.comNYU Leonard N. Stern, School Of Buisnness. Investment Valuation, Second Edition, Published by John Wiley & Sons, Inc., 2002. US$ 89.50

Here are some further quotes from the chapter called: "Evidence on Insiders and Investment Professionals."

"Money Managers in every investment style underperform the market index."

"..the average portfolio manager actually underfperformed the market….and these results have been replicated with mild variations in their conclusions."

"There is substantial evidence of irregularities in market behavior related to systematic factors such as size, p/e ratio's, and price to book ratio value ratios, as well as to time-the January and the weekend effects. While these irregularities may be inefficiencies, there is also the sobering evidence that professional money managers, who are in a position to exploit these inefficiencies, have a very difficult time consistently beating financial markets."

How is it then that we alert individuals have for years beaten the local Thai benchmark stock index?


1) Most Equity Funds must have at least 40 to 50 Million US$ to invest before they can be profitable (The Quest Fund here in Bangkok for example, has 49 mill US$ under management and while its performance record is OK, it comes no where near what we have shown here. Yet "Quest Fund" claims it is ranked the best performing fund in Thailand.)

2) Most Equity Funds and their money managers hence have huge (untold) restrictions in what they can actually own and how fast they can trade a less liquid & developed market. My own experience on this is that they have/had none or very little exposure in the best performing small growth stocks.

3) Note how this prominent author/book mentions growth investing and small cap investing as being two sectors, which do have excess returns over time. In Thailand most often they are one and the same. Thank you.

Best Regards,

Paul A. Renaud.