To any fund manager out there that truly believes you can beat the market, here is how you can sell me your fund:
We agree on an index and a time frame. You guarantee me the same return as the index within that time frame. If you beat the index, you keep 90% of returns ABOVE the index (and I get 10%). We both win, and you win big.
If you don't beat the index (within the time frame), you make up the difference (so I get the return to the index).
You’re probably aware that no fund manager would accept your offer. But it doesn’t prove that they don’t think they can beat the market (as misguided as that belief might be), it just means they’re not willing to take on an absurd amount of risk to prove it.
Exactly. No point being the one taking the risk - if the professionals don't dare take the risk then any non-professional (fund buyer) shouldn't either (under normal circumstances).
PS. Furthermore, an accurate comparison is not beating the index, it's beating it enough to cover the salary/compensation of the fund manager + some (with less risk! Risk = cost!)
Well I think many fund managers regularly take on risk to achieve higher returns. They just won’t take on 100% downside risk while being taxed 10% on the upside.
I think this gets at a deeper point I'm trying to make.
If you truly can consistently beat the market, you are already making a killing with your _own_ money.
If you want to use _my_ money to place your bets (presumably b/c you want to leverage your market beating ability), I want a guarantee (because I'm more than happy to take the return of the index).
I follow, essentially you're viewing it like a loan + interest + a minor stake in the venture. If the venture fails, you still expect to repaid loan + interest and your stake in the venture is worth $0.
Unfortunately no one will agree to this as long as everyone else is willing to invest _and_ shoulder the risk
It sounds like they're simply critically evaluating the claims of beating the market.
If you can't beat the market with your own money, you shouldn't be trying to do it with someone else's.
If you can beat the market with your own money, why are you so worried about the downside? There should be little risk for someone who claims to be able to beat the market.
If they say that's too much risk, they likely don't think they can consistently beat the market.
That's right, fund managers expect their clients to take 100% of the downside risk and tax their clients 20% on the up side.
Where I disagree with you is that fund managers regularly take risk. They never take risk themselves, rather they supply all of the risk to their clients.
You've just found a way to restate "they don't truly believe they can (consistently) beat the market."
On the flip side-- a passive fund manager would take 100% downside risk of the fund failing to properly track the index, and only in return for a modest fee. Stated differently-- passive funds can and do consistently track the market.
I don't think the risk is "absurd". Or, at least it's no different than the risk they ask any investor to take by charging them 1% of their portfolio for it to be "actively managed".
Plus, they are being compensated. I'm offering 90% of the returns above the index :-)
Active funds ask investors to accept 100% of the downside and get taxed on the upside. Actually it’s worse: they’re taxed on both the up and down sides.
If this is a terrible deal for fund managers then virtually by definition actively-managed funds are a terrible deal for investors.
The risk your (completely hypothetical) offer would involve is reputational. There's no reason for a funds manager to ever risk their reputation on your stunt since they are constantly risking money and reputation in the ways that they control. Indeed, one could almost certainly put together a bet similar to yours using derivatives and have the potential upsides and downsides without the reputational damage.
Of course, if you offered your bet to all comers and gave significant publicity, unknown "funds managers" would be happy to take you up, though they might well default if they lost.
In my eyes, "we have sincere faith in our ability to sustain higher-than-market returns on average" and "our risk management calculations tell us that we will have beat the market on average with very high probability" are the same statement.
The point of actively managed funds is not so much to "beat the market", it's to provide diversified returns via strategies that are uncorrelated with the market.
On average, the S&P500 has returned about 7% annually. If I had a strategy that returned 5% on average but was totally uncorrelated with the S&P, then you'd get the best overall long-term returns (maximize the geometric average of annual returns) by investing in a combination of my strategy and the S&P.
This is a kind of revisionism that mostly took off after Warren Buffet won his bet that hedge funds would not outperform the market over a 10 year time period.
The original goal and selling point of hedge funds was to produce consistent results regardless of the market's performance by using long and short positions to provide absolute returns in any market environment.
With that said, even if you accept the revisionism, it's untrue that actively managed funds are uncorrelated with the market. What is true is that selection bias makes it seem like they are since when interest rates rise and markets go through a down swing, the majority (and yes I mean more than 50%) of hedge funds go out of business. As such the only hedge funds that remain are the ones that happened to weather the storm so to speak.
I want to agree with you, except that almost all of the salescritters for these products promote them as "beating the market." They _have_ to sell them this way because if their customers had any idea what the whole-market returns actually were, they wouldn't pay extra for the privilege of a far riskier (and lower-performing, on average) investment.
And the S&P 500 returns more like 10% per year. A bit higher if you cherry-pick your start and stop dates. I've only seen people use 7% for portfolio value estimation purposes, after adjusting for an assumed 3% inflation.
Those returns depend on when you invest. The inflation adjusted annualized return of the S&P 500 was negative from January 2000 to January 2013 at -0.25%. The inflation adjusted total annual return from January 2000 to January 2024 was 4.5%.
The figure till 2013 was just food for thought. Inflation adjusted returns for the S&P 500 for the last 50 years are around 7-8%. I'm certainly not suggesting anyone stay out of a S&P 500 index fund, as I wouldn't take that advice myself. However, the return from 2000 to 2024 is not a cherry pick for anyone old enough to have had their money invested back in 2000, as it shows that there has only been a 4.5% real return on the money then invested since the 2000 peak.
Well then you could establish a simiar pay critera that beats the s&p 500 during recessionary moves of the index. Im guessing you wouldn't get many takers
No, it is likely the rate of return. There is generally no such mention of inflation in investment returns. The alternative to investing your dollar is to put it in a treasury (inflation tracked), so you can compare the value of your money against that as the lowest risk (the US defaulting) vs. other forms of risk.
The average return of the S&P 500 is around 10%, although you will see people use 7% as a shortcut to account for inflation when estimating the future value of their portfolios.
The citation of 7% as the true return isn't a "shortcut", though a nominal return of 10% could be argued to be, but an acknowledgement that total returns are not real without accounting for inflation. If an hypothetical index in a developing country rises by 50%, but inflation is 100%, then even though the nominal index returns may look impressive, it has actually had a negative real return, as the real inflation-adjusted value has decreased. The use of nominal terms for market returns is money illusion.
For the 50 year period from January 1974 to January 2024, the annualized inflation adjusted real return of the S&P 500 has been 7.04%, which is not a shortcut, but simply correct. The nominal annualized total return has been 11.14%, but it is an illusory return of value without being inflation adjusted.
An important component of a bet like this: you should base the win/lose calculation on returns after accounting for fees. The index fund likely has fees that are two orders of magnitude lower than the active fund. Otherwise, a random fund may beat a broad index just by chance.
Warren Buffett's very similar bet was done this way.
Sounds similar to recently launched buffer ETF products, specifically BlackRock and Innovator that hedge 100% of downside while capping your upside across different time horizons indexed to the S&P500.[1]
They don't guarantee you zero downside compared to investing in the index, though, but compared to putting your money under the mattress.
It's relatively easy to achieve a return profile like these promise with some combination of Treasuries and index options (at least while Treasuries pay 5%!), and the ETFs are doing this kind of financial engineering rather than promising to beat the market through stock-picking skill.
> “Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.”
You are not an UHNW individual/institutional investor, so no "fund managers" of any note are going to waste their time on this wager.
"Beating an index" is really easy. Up to $10MM you can choose most any financial instrument class in the U.S markets and have a good probability of finding alpha for a long time (that would beat the S&P500 18.40% YTD). Many proprietary trading firms, or market makers, or quantitative trading shops do this regularly. Discretionary and systematic funds? Usually not. If their processes worked consistently, they would have no need to take outside capital and deal with relationship management. They could simply use more leverage (not exactly, but simplified for the general reader).
This is also ignoring the fact there are no details in TFA about actual portfolio compositions or returns -- i.e. this is a PR piece.
If your NW is under <$100MM, you should be focusing on hyper-growth strategies -- and not mentally limiting yourself on what is basically financial propaganda.
Why would anyone take the other side of this bet? It's an incredible financial instrument, that anyone on the buyside would buy in an instant (as formulated -- ignored fees/tcosts etc).
> Why would anyone take the other side of this bet?
People accept this bet every single day… when they buy actively-managed funds.
Actually they accept a worse bet. Instead of taking 100% downside risk and being taxed on anything above the index, they’re taxed on both gains and losses.
You’re right that it’s an incredible financial instrument. Actively-managed funds are extremely profitable… for fund managers, who get paid out of investors’ assets in bad years and also get to skim off the gains in good years.
Something I don’t see talked about enough is the extent to which the rise of passive investing increases the extent to which passive investing is the best strategy. Passive investing is predicated entirely on either freeloading off of the decisions of actively managed portfolios, who will adjust the market prices of securities efficiently, therefore resulting in passively managed funds automatically owning the “best” stocks because the bad ones will fall out of the indices; or it is predicated on what is effectively a Ponzi scheme wherein if everyone passively invests the same, then that form of passive investing will yield the best returns.
For analogy, consider school students trying to get all the questions right on the test. The first scenario is equivalent to one student studying hard to find the right answers. The rest of the class copies his answers and benefits from his efforts. The other scenario is no student trying hard, them all failing, but succeeding because the teacher curves the grades.
Note that both of these scenarios, especially the second scenario, results in stock prices which become increasingly detached from the economic reality of companies in proportion to the extent to which passive investing becomes prevalent.
For instance, assume stock XYZ is a bad investment but is in the S&P 500. If 90% of funds are actively managed, maybe they can sell a sufficiently large amount of it to push it out of the S&P 500 and save the passive investors from owning it. But if 90% of funds are passively managed, even if XYZ is hot garbage, the 10% of passively managed funds cannot possibly sell enough to make up for the fact that 90% of the market participants are indiscriminately buying a terrible stock.
Passive investing breaks the market to some extent. The free market system is predicated on having rational participants, not zombie participants.
What you describe can be measured with return dispersion, as more people invest with passive index more opportunities arise for active investors. So they balance each other
Disclaimer, I work for a market-neutral fund, and have close friends high up in prop shops.
Presuming all strategies have a curve of diminishing marginal returns as assets under management increase, you would not expect any fund accepting outside money to have expected returns beating the market, but you would expect many of them to have a combination of correlation to the market and expected returns that would make them an attractive component in a basket of broad index ETFs and market-neutral funds. (Assuming risk-adjusted returns are the utility function being optimized. If variance is their preferred risk metric, this results in optimizing Sharpe ratio via mean-variance optimization, MVO.)
It's fair to assume that any fund manager is optimizing the sum of returns from their own personal investments in the fund plus fees from outside investors. They pick the place on the volume/risk-adjusted-returns curve that still keeps their fund attractive enough to outside investors, and maximizes their personal profits (personal returns plus fund fees).
If that optimal point on the volume/risk-adjusted returns curve for their particular strategy is at a point where risk-adjusted returns beat the market, then they maximize their returns by either never accepting outside funds (prop shops) or by not accepting additional funds and gradually buying out their investors (such as RenTech's famous Medallion fund).
So, (assuming diminishing marginal returns) it's not rational to simultaneously accept outside investment and beat the market on a risk-adjusted basis.
I suspect that many market-neutral funds could reliably beat the market on a risk-adjusted basis, but their volume/risk-adjusted-returns curve shape and their fee structures make it optimal for them to operate at a point on that curve where their expected returns are below the market.
Note that this rational self-interest optimization below market returns isn't bad for the investors. Under most fee structures, it ends up being close to maximizing total investor returns. Increasing percentage returns would mean kicking out some investors.
RenTech's Medallion Fund and many prop shops, and funds that are currently slowly buying out their investors seem to indicate there are at least some strategies where the optimal volume/returns trade-off is above market returns. You would expect all funds that are currently open to more outside investment to either be young and lacking capital or else have an optimal point on the volume/returns curve that is below market returns.
Note that as previously mentioned, a simple mean-variance optimization on a basket would allocate funds to both index ETFs and market-neutral funds returning a bit under the market on average. It's entirely possible that both fund investors and fund managers are being perfectly rational.
Of course, there are also plenty of people out there who fool themselves into thinking they know what they're doing. The world certainly isn't perfectly rational.
I'm just saying that in a perfectly rational world, assuming (1) utility function of risk-adjusted-returns (e.g. Sharpe ratio, resulting in mean-variance-optimization) (2) declining marginal returns on investment, you would expect all funds accepting outside investors (except for young funds desperate for money) to under-perform the market in expected returns.
Now, everyone talks about Sharpe ratio on the outside, but the particular risk models actually used internally by any fund are almost certainly not just variance of returns. I presume all funds simultaneously apply a mixture of commercially available risk models and internally developed risk models. Sharpe ratio is far from perfect, but it's a good least-common-denominator for discussion, and doesn't give away any secret sauce.
Side note: it would be rational for someone to take you up on your proposal and simply use index futures to take a highly leveraged position on your benchmark index. As long as they had enough money to make you whole in the case of bad tracking error and large downturns, their expected returns would be large. However, you wouldn't be very smart to take such an agreement instead of just getting leverage yourself. This demonstrates why risk-adjusted returns are usually more important than expected returns.
The claim is that there are no funds that can make a convincing argument that they will beat S&P.
When you say funds did "exactly that", the "exactly that" you're talking about is not the thing OP is asking for.
Taking on 90% of upside and 100% of downside is one way to make a convincing argument, and nobody does it.
Let's make the dice analogy. You can't make a convincing argument that you will roll a 5, even though people roll 5 all the time. Talking about people that rolled 5 in the past is proving entirely the wrong point.
Fundsmith for example has beaten the market for a long time (not this year though). I can also mention another Spanish fund that I know: Tercio Capital.
There are some research (instead of cherry picking/anecdotes). I don't have any links right now but basically half of the funds lose compared to the index (by law of nature - averages and all that). Furthermore, taking fees into account, just a few percentages make anything more (over time) - which is probably within scope of randomness.
In general hard working prudent value investors are able to beat the index. It's just that those are very few. I mean Buffet has done it for half a century, that's not a coincidence.
Given the statistics and number of investors involved, it seems like an absolute certainty that a few people would beat the index for the entirety of their lives simply by chance.
Find me the one who knows they got there by chance alone...
It's very easy to create a narrative around random movements. I expect that anyone who is ahead of the market creates such a narrative, and declare themselves a genius. And then half of the geniuses underperform each year, same as every year...
Half will beat index by definition. The key is to beat it including the cost of beating - and we've also seen that the extra value have generally been captured by the fund managers - not the fund buyers.
We agree on an index and a time frame. You guarantee me the same return as the index within that time frame. If you beat the index, you keep 90% of returns ABOVE the index (and I get 10%). We both win, and you win big.
If you don't beat the index (within the time frame), you make up the difference (so I get the return to the index).