Can You Pick Losing Stocks?

(MoneyWatch)  My last post discussed market-neutral funds, which aim to provide equity-like returns with bond-like risk by identifying winning and losing stocks, then taking long or short positions on those stocks. As I discussed, these funds have failed to meet their objectives. Their failure adds to the already overwhelming body of evidence on the inability of active managers to persistently add alpha after the expenses of the effort. And that's the real test of whether markets are efficient.

It also adds an interesting twist. The failure of market-neutral funds to outperform means managers have a difficult time not only picking winning stocks, but losing stocks as well. Consider the following.

Citing work by author and money manager Michael Mauboussin, Ariel Investments founder and chairman John Rogers suggested that an appropriate test of an activity where skill is rewarded is the extent to which a participant can lose on purpose. For example, Roger Federer can almost always beat an amateur tennis player, but he could choose to play badly enough to lose to anyone. In contrast, it would be impossible to lose consistently to a slot machine on purpose since the outcome is determined by chance alone.

Rogers decided to have some fun with this insight and asked 71 of his staff to pick 10 stocks that would underperform the market for the second quarter of 2009. Only 19 succeeded. The other 52 (73 percent) tried to lose on purpose but failed miserably. The average return of the "loser" picks was 30 percent, compared to a total return of 16 percent for the S&P 500 Index.

The difficulty experienced by Ariel's staff is further evidence that market prices are the "best estimate" of their fair value -- the market is highly efficient. Obviously, Rogers can't admit to that because that would be committing economic suicide. Rogers' funds charge investors high fees (in excess of 1 percent) for the privilege of having Ariel manage their assets. The problem is that Ariel's results look more like the records of Roger Federer's opponents. Morningstar gives the Ariel Fund just two stars and both the Ariel Appreciation Fund and the Ariel Focus Fund just three stars. If Ariel could truly exploit market mispricings on a persistent basis, we would expect to see five-star ratings.

Follow the series:

• Part one: Equity-Like Returns With Bond-Like Risk? Not So Fast!
• Part two: Can You Pick Losing Stocks?
• Part three: When You Wish Upon a Morningstar