Its an old joke in finance.. Two economists walking down a street spot a 100 rupee note. When one of them rushes to pick it up, the other one says “Don’t waste your efforts.. If it was really a 100 rupee note, someone would have already picked it up”….
The principles of arbitrage stares at us each day. Lets say we start driving to our work places at 8.30 AM everyday and take 45 minutes to reach office. We could probably reach faster and take only 30 minutes if we manage to start at 8 AM. However, this is only possible if the following two things are true:
1. We sacrifice some sleep/ or make some changes to our morning schedule so that we are indeed able to start at 8 AM
2. Others dont think alike. Because if everyone thinks like us, then the opportunity of reaching faster is lost as we are met with the same amount of traffic even at 8 AM
These are the two fundamental principles of arbitrage:
1. There is nothing called risk-free profits. If you want to make a profit of “15 minutes”, you need to make some sacrifices
2. If the profit is indeed risk-free, then it only stays for short time periods. Say, you find an alternative route to your work place and so manage to reach office in 30 minutes despite starting at 8.30 AM. You will enjoy a “monopoly” on this route only for a short time, as it is not going to take others too long to copy you and use this alternative route. The result - Traffic jams are back in place in some time
Now lets go back to our original question. Can fund managers really beat market performance, consistently?
For the most part, markets are considered highly efficient. There are lakhs of individuals and institutions who process the information which hits the market (almost on a real time basis) and take rational actions. So we can almost rule out “arbitrage” as an option to make consistent profits in the markets.
Now, the only other way to consistently beat the markets is real skill. So can skilled investors consistently make abnormal trading profits? Unfortunately, the empirical evidence does not seem to suggest so. There have been various studies carried out in the past and historical evidence suggest that while fund managers have outperformed markets during some periods they have been averaged out by other periods of relative underperformance. So over long periods of time, fund managers have at best equalled market performance.
Now before you write off all fund managers as “average”, I will have to make the differenciation clear and salute some real markets heroes like Warren Buffet, Peter Lynch, John Templeton and the likes who have amlost consistently outperformed markets throughout their careers. However, be cognizant to the fact these legends are indeed exceptions.
Do your own research and satisfy yourself that the fund manager with whom you are trusting your money, is part of this elusive league of consistent outperformers. If they are not (which would be the fact in 99% of the cases) why pay a fund management fee to them? Why agree to additional charges such as entry and exit loads?
Aren’t you better off investing in a simple index fund?