By Cavanaugh Asset Management

Imagine a casino full of roulette wheels. Even though we know that how well any given gambler does is based entirely on luck, we also know that some will happen to be luckier than others. A small percentage may even win consistently over several days of gambling. These fortunate individuals may claim otherwise, but we know they have not discovered some secret to playing roulette, their lucky streak is simply within the realm of chance.

Critics of indexing often point to those funds which actually have outperformed market averages over the long-term. However, the theory of market efficiency does not claim that its impossible to outperform the market. Rather, its states that performance is based largely on luck, and therefore there is no reason to believe that any given portfolio will outperform any other portfolio going forward.

On the chart below, the red line represents the number of domestic funds with a particular range of annual return for the ten years ending December 2000. The blue line is the returns we would expect from random chance, assuming that the random returns center around the same average as actual returns. The left half of the graph represents below-average funds, and the right side of the graph represents above-average funds. The fact that the red and blue lines are on top of each other indicates that the number of above average funds is no different than we would expect if fund returns were based entirely on luck. In other words, if stock picking involved no more skill than roulette playing, then returns would look like the blue line. In reality returns look like the red line. (See below for more information on reading this graph)

The bottom axis of this graph represents returns either over or under the average fund return, i.e. zero represents the average return, and +10% would mean performance that was 10% better than the average annual return. The height of the curve at a given point represents how many funds had that level of performance either above or below average. Not surprisingly, the largest number of funds performed within a small deviance from the average.

In forming the "random" line (blue line), we generated a normal curve. A normal curve is a mathematical representation of the range of random probabilities. If all fund managers had the same stock picking skill, returns would look like the blue line.

The fact that the two lines are virtually the same suggests that fund returns might be random. Another conclusion is that the number of fund managers who have above-average returns over the last ten years is no different than would be by chance. Although we cannot prove whether any given manager has any stock picking skill, this graph does cast serious doubt on whether portfolio managers in general have some kind of skill for market outperformance.

Data as of 12/31/2000 from Morningstar

04/04/2001

This article is the property of Cavanaugh Asset Management, and is reprinted with permission. Cavanaugh Capital Management's mission is to provide equity clients with a diversified portfolio of index funds while also providing professional monitoring and reporting.