Year after year, it gets harder for mutual funds to beat the index. And even if the top stock pickers hit high marks one year, it always seems like they fade to mediocrity in the following year. There are, of course, high fees associated with mutual fund management; at the same time, some of the largest mutual funds consistently underperform the market.

As a result, you may be questioning whether or not mutual fund managers can really pick stocks. If mutual fund managers can successfully pick stocks, then one would assume that the price of active management for mutual funds is worth it. But if the opposite is true, are index funds actually the best bet for investors?

Picking Stocks in an Efficient Market

For anyone who has taken a basic finance course at the college- or university-level, you may recall the efficient market hypothesis (EMH). The EMH theory originated with Eugene Fama at the University of Chicago; in the early 1960s, Fama presented his argument that the financial markets are—or can be—very efficient.

Key Takeaways

  • There high fees associated with mutual fund management; at the same time, some of the largest mutual funds consistently underperform the market.
  • As a result, you may be questioning whether or not mutual fund managers can really pick stocks.
  • The efficient market hypothesis (EMH) calls into question the viability of the consistent ability to outperform the market by exploiting information that may not be fully reflected in the price of a security.
  • 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.
  • 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.

This 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.

While this theory does not necessarily negate the concept of stock picking, it does call into question the viability of the consistent ability 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, they believe 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 they believe is worth less now or in the future; again, this involves exploiting information that has not been reflected in the price of the stock.

The EMH is generally presented 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 are the fact that every investor has a unique investment style and ways of evaluating an investment. One may use technical strategies, while others may rely on fundamentals; still others may resort to simply using the roll of a dice or a dartboard.

There are also many other factors that influence the price of investments, from emotional attachment, rumors, the price of the security, and supply and demand. Part of the reason the Sarbanes-Oxley Act of 2002 was implemented was to increase the efficiency and transparency of the markets because access to information for certain parties was not being fairly disseminated. In the aftermath of this Act, it's hard to say how effective it was. However, at the very least, it made people more aware and held some parties more 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.

Stock Pickers

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 a famed stock picker 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; he may have 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 this question is to evaluate how portfolios managed by stock pickers have performed. It's also helpful to 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 the case, all investments should be placed inside an index fund.

Taking out management fees, the 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 always 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 the majority (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 they may not have picked in order 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; every year, some managers successfully pick stocks and beat the markets. However, few of them do this consistently over time.