Will there be a Santa Claus rally this year? The hedge funds better hope so. Just owning the market in an index fund is set to demolish active managers once again, according to data from the University of Pennsylvania.
Importantly, this is not just a game in which the clock has run out and managers get to start over. For retirement investors, a lost year really hurts. Compounding money in a risk-adjusted portfolio is the only reasonable way to build a truly reliable retirement. Sitting out one or two years with a low return creates real long-term pain.
The Wharton study found that just 9.3% of active mutual funds were ahead of the S&P 500 as of Sept. 30. The previous low-water mark for active funds was 12.9% beating the index, set in 1995. It’s likely to turn out to be worst performance net of fees since 1989, said Denys Glushkov, a senior researcher at Wharton Research Data Services.
Risk-adjusted investing is an important concept, one that many people misunderstand. If you are going to be in the market for many years — and that’s what retirement investors do — the goal is not to grab a market-beating year. Rather, you should do nothing at all.
To quote John Bogle, founder of the Vanguard Group and a longtime proponent of passive investing: “One of my favorite rules is ‘Don’t peek.’ Don’t let all the noise drown out your common sense and your wisdom. Just try not to pay that much attention, because it will have no effect whatsoever, categorically, on your lifetime investment returns.”
The reason why you don’t peek is risk. If you target a specific return, say, 8% annually, the next question you must ask yourself is, “How much risk can I withstand to reach for 9%?”
A young person just starting a new job might answer that question quite differently from a 60-year-old. Given the decades of investing ahead of a 22-year-old, a decline in the stock market of 20% or 30% is not a disaster. In fact, it’s an opportunity: Stocks are on sale!
For the 60-year-old, a huge decline can be quite a headache. In retrospect, the mid- or late-career saver should not have been taking on such high risk. Stocks are likely to bounce back, but it will be harder to mentally absorb the impact and often the result is panic selling.
The active management industry has an increasingly difficult case to make if year-end results stay true to the trend. The problem now is that some of those legacy managers might take new, high-risk bets in order to “fix” mistakes they made earlier in the year.
The larger concern is continually underperforming the stock market, year after year. Just by using the Rule of 72, we know that a 10% return will double a portfolio in a little more than seven years (7.27 to be exact).
An active manager who returns 5% net of fees needs close to double the time to double your retirement balance (14.21 years). Do that for five years in a row and you enter into a game of catch-up that implies ever-higher returns and ever-higher risks in order to work out.
Hedge funds are in even worse shape. They’re returning about 2% after fees. You would need 35 years to double your money. The risks are entirely disproportionate to the outcome. Understandably, hundreds of hedge funds have shut down this year.
The answer is not that complicated. Build a simple, low-cost portfolio of index funds and rebalance them year in and year out. Nothing could be easier to do.