Beating the Market: Myth or Reality? Let’s Investigate!

In the first half of 2023, a substantial 57% of actively managed mutual funds and ETFs managed to surpass their respective benchmarks. This might initially suggest that consistently outperforming the market has become more feasible. However, it’s crucial to maintain perspective and resist the temptation to believe that consistently beating the market is an easy feat, especially when managing retirement portfolios like 401(k)s and IRAs.

A recent report from Morningstar may seem optimistic, revealing that a significant portion of actively managed funds and ETFs are exceeding their benchmarks. Notably, in the “U.S. Small Blend” category, an impressive 74.7% of funds and ETFs outperformed their benchmarks. These statistics deviate from what we’ve grown accustomed to over the years.

Nonetheless, the reality is more complex than this report might suggest. It’s not because Morningstar’s calculations are inaccurate, but rather because when one group of active managers beats the market, another group inevitably lags behind. Moreover, when transaction costs are factored in, the average market-weighted return of all active managers must, by necessity, fall below the market’s overall return.

So, it’s crucial to understand that the market hasn’t become inherently easier to beat. This argument echoes the insights put forth in a groundbreaking article by William Sharpe, the 1990 Nobel laureate in economics, published in the January/February 1991 issue of the Financial Analysts Journal. Sharpe’s “The Arithmetic of Active Management” demonstrates that, on average, active managers are bound to trail broad market indexes, a conclusion derived from basic mathematical principles.

Sharpe’s analysis challenges various assertions about why numerous funds and ETFs have seemingly outperformed the market this year. Some claim that the increasing dominance of index funds has made the stock market less efficient, making it easier to beat. Others argue that managers are now more intelligent and sophisticated, while some credit artificial intelligence for enhancing market-beating capabilities.

However, Sharpe’s arithmetic-based argument acknowledges that isolated instances of individual managers surpassing the market can occur, primarily over the short term. But for every manager who outperforms, another must, by necessity, underperform, turning beating the market into a zero-sum game before transaction costs and a negative-sum game afterward. This is why, as illustrated in the accompanying chart, the percentage of large-cap growth funds consistently beating their benchmarks averages well below 50%.

Drawing from over 40 years of experience in the industry, it’s unlikely that many will be swayed by Sharpe’s argument and will persist in believing that they can consistently beat the market. One practical solution, which balances your belief with Sharpe’s logic, was proposed by the late Harry Browne, editor of “Harry Browne’s Special Reports.”

Browne’s recommendation involves creating two distinct portfolios: a Permanent portfolio and a Speculative portfolio. The former comprises the majority of your assets and is invested in index funds for the long term with minimal changes. The Speculative portfolio, on the other hand, accommodates your risk-taking tendencies as you attempt to outperform the market.

Browne’s approach is astute because it acknowledges both the mathematical veracity of Sharpe’s argument and the psychological reality that many investors believe they are above average. By primarily relying on the Permanent portfolio, you safeguard your retirement financial security while, in your Speculative portfolio, you satisfy the part of your psyche that aspires to beat the market.

While there will be instances, like the current year for actively managed mutual funds and ETFs, when your Speculative portfolio outperforms the Permanent one, it’s likely that, over the long term, the latter will yield superior results. Nevertheless, as long as you structure your two portfolios prudently, there’s no harm in attempting to prove this theory wrong.