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Results Depend on the Level of Competition

One of the reasons active fund managers have such a difficult time outperforming is their level of competition. Here's a hint: It's not just other fund managers. Consider the following:

Roger Federer is the greatest tennis player of his era, and perhaps the greatest ever. No one would consider it luck that he won a record 15 Grand Slam singles titles. He is so persistently outstanding that he has reached at least the semifinals of the last 22 Grand Slams -- more than doubling the previous record.

What is important to understand is that Federer's competition is other individual players. In terms of individual skills:

  • Andy Roddick has a better serve
  • Andy Murray has a better backhand
  • Fernando Gonzalez has a better forehand
  • Rafael Nadal has a better baseline game, is a better conditioned athlete and is a superior player on clay
  • Radek Stepanek has a better net game
  • David Ferrer is faster
Yet, Federer is the better player. However, the world of investing presents a different situation. Dr. Mark Rubinstein, of the University of California, Berkeley, provided this insight:
  • "Each investor, using the market to serve his or her own self-interest, unwittingly makes prices reflect that investor's information and analysis. It is as if the market were a huge, relatively low-cost, continuous polling mechanism that records the updated votes of millions of investors in continuously changing current prices. In light of this mechanism, for a single investor (in the absence of inside information) to believe that prices are significantly in error is almost always folly. Public information should already be embedded in prices."
Rubinstein's point is the competition for an investment manager isn't other investment managers, but the collective wisdom of the market. As author Ron Ross wrote: "The quest for market-beating strategy boils down to an information-processing contest. The entity you are competing against is the entire market and the accumulated information discovered by all the participants and reflected in prices."

Rex Sinquefield, former co-chairman of Dimensional Fund Advisors, put it this way: "Just because there are some investors smarter than others, that advantage will not show up. The market is too vast and too informationally efficient."

While the competition for Federer is other individual players, the competition for investment managers is the entire market. It would be as if Federer always faced an opponent with Roddick's serve, Nadal's baseline game, etc. If that had been the case, Federer would not have produced the same results.

It's important to understand that the results of any game are more dependent on the skill of the competition than on the skill of the individual competing. In the investment world, the competition is tough. Since as much as 80 to 90 percent of the trading is done by institutional investors, it's difficult to think of a large enough group of victims to exploit.

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