After costs, only the top 3% of managers produce a return that indicates they have sufficient skill to just cover their costs, which means that going forward, and despite extraordinary past returns, even the top performers are expected to be only as good as a low-cost passive index fund. The other 97% can be expected to do worse.
Interpretation
Most managers fail to outperform a simple index fund after fees are taken into account.
Eugene Fama's quote highlights the reality of investment management, emphasizing that only a small percentage of managers have the skill to deliver returns that surpass the costs associated with their management. Despite some managers showing impressive past performance, this quote suggests that most will struggle to meet or exceed the returns of low-cost index funds, illustrating a significant challenge in active investing.
In practice
This quote can be used in a financial seminar to illustrate the challenges of active management.
The problem that people don't understand is that active managers, almost by definition, have to be poorly diversified. Otherwise, they're not really active. They have to make bets. What that means is there's a huge dispersion of outcomes that are totally consistent with just chance. There's no skill involved it. It's just good luck or bad luck.
Market timing doesn't work. If all the bubbles and all this mispricing really exist, how come so few people see it before it turns out that way?
There's quite a bit of evidence that even professionals don't show any ability to pick stocks or to predict market rollbacks. Most of the people we identify as skilled based on returns have probably just been lucky.
Liquidity is a good proxy for relative net worth. You can't lie about cash, stocks, and bond values.
People who want to know how stocks fared on any given day ask, "Where did the Dow close?" I'm more interested in how many stocks went up versus how many went down. These so-called advance/decline numbers paint a more realistic picture.
Money management has been a profession involving a lot of fakery - people saying they can beat the market, and they really can't.
There will always be bull markets followed by bear markets followed by bull markets
But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?
When I trade, I don't have an agency problem; I have my neck on the line. When a bank or banker trades, it's not his neck on the line.
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