Why you can't beat the market

Actively-managed unit trusts have continued to deliver below-par returns with above-par charges. Figures from Trustnet show that in the last five years the All-Share index tracker funds run by L&G, M&G and F&C, to name but three, outperformed most funds in the all companies sector.

Granted, things have been different recently. In the last 12 months, for example, L&G's UK index fund has returned just 13.2 per cent, ranking it a lowly 265th out of 405 funds.

But there might be a simple reason for this. In the last 12 months many big shares such as Tesco, BP, Royal Dutch and Anglo American have done poorly. This has dragged down the index relative to most shares. With most stocks beating the market, you'd expect stock-pickers to outperform.

However, there's no reason to suppose that this tailwind for active managers will continue. If the Chinese economy picks up, so might investors' interest in the mega-cap commodity producers that did poorly last year. And Gibrat's law (more of a tendency actually) tells us that companies' growth is independent of their initial size, so big stocks are as likely to do well as smaller ones over time; if this were not the case we'd see either companies becoming more equally sized over time, or one or two firms dominate the whole economy, and neither seems to have happened.

All this raises the question: why do stock-pickers, on average in the long term, do so indifferently?

The standard answer is that markets are informationally efficient, and so you just can't beat them by studying companies.

But I want to suggest another reason which is often overlooked. It's that good companies don't necessarily deliver good growth, and so even if a stock-picker can identify a well-run company, he'll not necessarily enjoy great returns.

The best evidence for this comes from a magisterial survey of companies' growth by Alex Coad at the Max Planck Institute in Germany. "Financial performance and productivity do not predict growth," he's concluded. Growth appears to be an idiosyncratic and fundamentally random process. This is consistent with the finding in a classic paper by three US economists: "There is no persistence in long-term earnings growth beyond chance, and low predictability even with a wide variety of predictor variables."

How can this be? One possibility is that good performance isn't necessarily scalable. The company that is efficient and well-managed with (say) £1bn of sales might have to invest heavily and reduce profit margins in order to grow, or incur diseconomies of scale if it does so.

There's a second reason - the market does not necessarily favour the best companies. We think - correctly - of market forces as being like a Darwinian selection process. And surely, this means the survival of the fittest, doesn't it?

Not always. For one thing, it is 'survival of the fittest', not 'growth of the fittest', and it's usually the latter that investors are looking for.

Sometimes, though, market selection doesn't favour 'good' companies. Instead, selection can sometimes operate randomly. A study of companies' fate in the 1990s recession by Paul Gregg of the University of Bath and the late Paul Geroski concluded that "market selection criteria may be rather myopic". Some apparently sound companies got into big trouble when aggregate demand fell while some apparently poorly run companies thrived.

Many dinosaur species were well-adapted to their environment, but that didn't enable them to survive the random shock of an asteroid strike. A similar thing is true of companies facing swings in aggregate demand. The author of The Book of Ecclesiastes made a sound economic point when he wrote that: "The race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill; but time and chance happeneth to them all."

Now, you might object here that when you look for under-priced shares, what you're looking for is not companies that will grow well - either in the short- or long-term - but merely ones that investors are overlooking.

True. But this brings us to another problem with market selection, pointed out by Bjorn Christopher Witte of the University of Bamberg, market forces can sometimes select against the fit in favour of the stupid. The fund manager who avoided tech stocks in 1998 because he believed them to be over-priced, or banks in 2005 because he thought they were taking on too much risk was proved right eventually. But months of underperformance might have cost him his job, or caused him to close his position, before being vindicated. Being 'right' when the market is selecting 'wrong' is no use. Maynard Keynes's famous saying that "markets can stay irrational longer than you can stay solvent" is a cliché because it's true.

I say all this for a reason. Many people find the idea that markets are efficient implausible. Surely, they say, people are too stupid and too irrational to process complex information rationally.

Maybe. But it doesn't follow from this that it's possible to systematically beat the market. It could be that we cannot do so because the economy and corporate behaviour are so unpredictable that we simply cannot identify future winners and losers.

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