Year after year it gets harder for mutual funds to beat the index. It seems like the top stock pickers hit high marks one year then fade to mediocrity the next. With the high fees associated with mutual fund management, and some of the largest funds consistently underperforming the market, you have to question whether mutual fund managers can really pick stocks. For those who invest in mutual funds, it's a very good question: If, over time, mutual fund managers can successfully pick stocks then the price of active management is worthwhile—and if not, are index funds the best bet? (See also: Efficient Market Hypothesis: Is the Stock Market Efficient?)
Picking Stocks in an Efficient Market
For anyone who has taken Finance 101, you may recall the efficient market hypothesis (EMH). Eugene Fama from the University of Chicago presented his argument in the early 1960s that the financial markets are or can be very efficient. The concept implies that market participants are sophisticated, informed and act only on available information. Since everyone has the same access to that information, all securities are appropriately priced at any given time. This theory does not necessarily negate the concept of stock picking, but it does call into question the viability of consistent abilities to outperform the market by exploiting information that may not be fully reflected in the price of a security.
For example, if a portfolio manager purchases a security, he or she believes that it is worth more than the price paid now or in the future. In order to purchase that security with a finite amount of money, the portfolio manager will also need to sell a security that he or she believes is worth less now or in the future, again exploiting information that has not been reflected in the price of the stock. The concept of an efficient market was expanded upon in a book that is now a staple for those who study finance: "A Random Walk Down Wall Street" by Burton Malkiel.
It is taught that the EMH comes in three distinct forms: weak, semi-strong and strong. Weak theory implies that current prices are based accurately on historical prices; semi-strong implies that current prices are an accurate reflection of financial data available to investors; and strong form is the most robust form, implying that all information has basically been included in the price of a security. If you follow the first form, you are more likely to believe that technical analysis is of little or no use; the second form implies that you can toss your fundamental security evaluation techniques away; if you subscribe to the strong form, you may as well keep your money under your mattress.
Markets in Reality
While it is important to study the theories of efficiency and review the empirical studies that lend creditability, in reality, markets are full of inefficiencies. One reason for the inefficiencies is the fact that every investor has a unique investment style and ways of evaluating an investment. One may use technical strategies while others rely on fundamentals, and still others may resort to using a dartboard. There are also many other factors that influence the price of investments, from emotional attachment, rumors, the price of the security, and good old supply and demand. Part of the reason Sarbanes-Oxley Act of 2002 was implemented was to move the markets to greater levels of efficiency because the access to information for certain parties was not being fairly disseminated. It's hard to say how effective this was, but at least it made people aware and accountable.
While EMH does imply that there are few opportunities to exploit information, it does not rule out the theory that managers can beat the market by taking some extra risk. Most contemporary stock pickers fall in the middle of the road; although they believe that most investors have the same access to information, the interpretation and implementation of that data are where a stock picker can add some value.
The process of stock picking is based on the strategy an analyst uses to determine what stocks to buy or sell and when to buy or sell. Peter Lynch was one of the most famed stock pickers who employed a successful strategy for many years while at Fidelity. While many believe he was a very smart fund manager and topped his peers based on his decisions, the times were also good for stock markets, and he had a little luck on his side. While Lynch was primarily a growth-style manager, he also used some value techniques blended into his strategy. This is the beauty of stock picking: No two stock pickers are alike. While the main varieties are in the growth arenas, the variations and combinations are endless and unless they have a strategy that is absolutely written in stone, their criteria and models can change over time.
Does Stock Picking Work?
The best way to answer that question is to evaluate how portfolios managed by stock pickers have performed, and open the debate of active vs. passive management. Depending on what periods you focus on, the S&P 500 typically ranks above the median in the actively managed universe. This means that usually at least half of the active managers fail to beat the market. If you stop right there, it's very easy to conclude that managers cannot pick stocks effectively enough to make the process worthwhile. If that's case, all investments should be placed inside an index fund.
Taking out management fees, transaction costs to trade and the need to hold a cash weighting for day-to-day operations, it's easy to see how the average manager underperformed the general index because of those restrictions. The odds were just stacked against them. When all other costs are removed, the race is much closer. In hindsight, it would be easy to have suggested investing solely in index funds, but the allure of those high-flying funds are too hard to resist for most investors. Quarter after quarter, money flowed from lower-performing funds to the hottest fund from the previous quarter, only to chase the next hottest fund.
The Bottom Line
The success of stock picking has been hotly debated, and depending on whom you ask, you will get various opinions. There are plenty of academic studies and empirical evidence suggesting that it is difficult to successfully pick stocks to outperform the markets over time. There is also evidence to suggest that passive investing in index funds can beat over half of active managers in many years. The problem with proving successful stock picking abilities is that individual picks become components of total return in any mutual fund. In addition to a manager's best picks, in order to be fully invested, the stock pickers will undoubtedly end up with stocks that he or she may not have picked or needs to own to stay in the popular trends. For the most part, it is human nature to believe that there are at least some inefficiencies in the markets and every year some managers successfully pick stocks and beat the markets. However, few of them do this consistently over time.