How to Measure Good, Bad Stock Pickers

In the middle of today’s bull market, you might expect a good performance from stock-picking fund managers.

If they can’t outperform major stock-market yardsticks like the S&P 500 when it’s breaking record highs (this time above 2,000), then at the very least they should be able to perform on par.

But have they? Typically, two-thirds of active fund managers lag the performance returns of low-cost broadly diversified index funds and ETFs.

During the first half of 2014, though, about three-quarters of active managers underperformed, according to a recent Vanguard study.

Indexes that track the performance of hedge fund managers show a similar pattern of widespread market underperformance.

Plus, since the recovery from the financial crisis of 2008, hedge funds as a group have lagged in almost every asset/strategy category.

Compared to mutual funds, hedge fund managers charge a premium for their stock-picking services. As most investors realize far too late, the premium paid is an awfully high hurdle to obtaining market-beating results.

The hedge fund industry, generally speaking, has turned into a playground of upper-class stock picking with low-class results. (Where are the customers’ yachts?) 

We know the track record of professional stock pickers is poor, because that’s what the numbers say.

We also know the track record of amateur stock pickers is even worse, but sometimes it’s more difficult to quantify with raw numbers.

Unlike professional money managers, we can’t group, categorize and neatly track the stock-picking performance of Uncle Jimmy and Aunt Ethel or the 50 million other gunslingers like them.    

Besides comparing investment returns to the broad indexes, investor can measure the lack of prowess of some stock pickers by comparing their selections to a peer ETF that matches the same industry sector as the stock.

Let’s look at three quick examples of how this is done.