The investment management business has suffered from investors moving their money to index funds, which have much lower fees and are purely mechanical in their investments. Also, much investor money has been diverted to private equity and hedge funds in the belief that those investments offer higher returns. The Efficient Market Hypothesis suggests that it is impossible to outperform the market, yet numerous professional investors substantially underperform it, which by the EMH ought to be equally impossible. Yet investment managers are not stupid; they are by and large among the most intelligent and well educated of mankind. I would suggest that the problem is structural: the act of managing money for somebody else, whether a client or a committee that can remove your job, produces incentives that are highly detrimental to good investment performance.

I manage my own modest investment portfolio. I have never been remotely tempted to use a “financial adviser” (I am nowhere near rich enough to merit a good one anyway). When I finally descend into babbling imbecility, my son, the ultimate beneficiary of what is left over, will take over making investment decisions. While there are theoretical conflicts about immediate income versus preservation of capital, he will basically at that point be managing his own money and so will do the good job of which I am confident he is capable, without recourse to outside advice.

I am not necessarily convinced that my son and I are more capable than the average professional investment manager, or even than the average “financial adviser” – a much lower hurdle. Nevertheless, we have one enormous advantage over a professional investment manager: we are acting for ourselves, so there is no chance of an argument over strategy with the investment manager who was managing our portfolio. (If we managed the money jointly, such an argument could of course arise, but we have far more sense than do so; the job is mine until I am obviously incapable, after which it is unequivocally his.)

Any investment manager worth his salt has an established methodology, which is not simply to follow the herd (if he followed the herd, his clients could save a lot on management fees by investing in index funds, the ultimate herd investment). That strategy will be questioned by his clients in two distinct periods. First, it will be questioned when investment values generally are falling, at which point the client will be generally discontented and want to sell up and move entirely into cash. If the decline becomes prolonged, this desire may well become irrational, forcing the investment manager into defensive actions at the bottom of the market, and preventing a full recovery when conditions improve. Here the individual investment manager is more likely to get fired than the institutional one; an institutional “Review Committee” will not generally have the alternative of firing the manager and moving entirely into cash.

The other danger to an investment manager occurs if the market is exceptionally strong and he is substantially underperforming it. If the investment manager is any good, this is most likely to happen when he refuses to follow some silly market fad, for example tech stocks in 1998-2000, financials in 2003-06 or AI stocks in the last two years. Individual investors will resent his activity, because they will think they could do better themselves by following the fad. Institutional investors will be an even greater danger to the Investment Manager’s job; they will review his performance quarterly against the “benchmark” of the index, and a couple of quarters of underperformance against the index will very likely result in him getting fired.

For both of these reasons, the wise investment manager will mimic an index fund, making small alterations to ensure it is not obvious he is doing so, since mimicking an index fund will secure him against all risks except the irrational individual investor who decides to exit the market altogether. He will confine his investment eccentricities to his own private portfolio, where he is not endangered by “underperformance.”

The legendary investment managers did not have this problem. “Benchmarking” investment portfolios against market indices did not become a fad until the 1980s, and while index funds were invented in 1974, they did not form an important market segment until around the 1990s. Benjamin Graham (1894-1976) wrote his seminal “Security Analysis” in 1934; it was essentially a manual on how to recognize real value in investments and avoid the bubble investments of the late 1920s (not that the 1920s bubble was especially extreme by more recent standards). At no point did that first edition suggest “benchmarking” your investments against market indexes.

That is how Graham’s pupil Warren Buffett was able to keep all his clients in his private investment partnerships from 1956 to 1969 and thereby build a reputation as a genius investor. From 1970, he was chief executive of Berkshire Hathaway Inc., not an investment vehicle per se but a textile company that he developed into a conglomerate and then later into an investment company when his investment genius had become universally accepted. Only since about 1990, when he injected funds into Salomon Brothers, has Buffett been universally known as primarily an investment genius; his track record since that date is far less outstanding.

At the other end of the investment management spectrum is Cathie Wood of ARK Investment Management, fad chaser extraordinaire. She buys emerging high-tech companies in fields such as AI, blockchain, biomedical technical technology and robotics – all the currently fashionable stuff, in other words. Given that to the end of 2024 the U.S. was in a more or less perpetual bull market, fueled by budget deficits and copious money printing, you would think her performance would have been stellar. Alas, no.

Since her flagship ARK Innovation ETF (Nasdaq:ARKK) went public in 2014, its shares have risen 130%, an average annual return of 8.7%. That sounds decent, but the Standard and Poor’s 500 index has returned roughly 270% over that period, or an annual average of 14%, far above its long-term average. In other words, even in an artificially prolonged bull market in which Wood’s investment style has been uniquely favored, her fund has substantially underperformed, even including her stellar return of 153% in 2020. This year, as the bubble finally begins to deflate, her return has been an unappetizing negative 19% compared with negative 10.1% on the S&P 500 Index.

Ms. Wood is a highly intelligent woman and very experienced. Her investment style doubtless attracted investors into ARKK in its early years. However, it is about as far from Benjamin Graham’s eternal verities as you can get, and the results show the cost of ignoring those verities. Like other investment managers, she is paid to manage by a certain style, in her case fad-chasing; her investment returns show that chasing fads, however successful in attracting money to a new fund, is not a sensible way to manage investments in the long run. Her track record also shows that much of the money can flow out as quickly as it flowed in. Notably, it also falsifies the Efficient Market Hypothesis: if it is possible for an intelligent fund manager to underperform the market so badly for so long a period, it must be equally possible to outperform it!

So, what can we conclude? The main conclusion, I think is that managing somebody else’s money is a horribly difficult job, unless you wimp out and track the indexes, which an increasing percentage of the market’s investment capital is doing. The problem with that is that the market’s function in allocating investment capital is thereby lost. If everybody indexes, there becomes no way of differentiating between one share and another. In periods of low interest rates, such as the last decade, it becomes in management’s interest to leverage the company as far as possible, because the cost of the leverage is small, and you may earn the market average return while getting your capital through cheap debt – a recipe for genuinely superior returns, until the crash comes.

In ending, none of this applies to managing your own money. If you earn the full benefit of returns, you won’t over-leverage, because you don’t want to go bankrupt – even in today’s wimpy world, the costs of individual bankruptcy greatly exceed the money lost. Whatever investment strategy you have, you will have some idea of when it is likely to be suboptimal and hence will tailor your investments towards greater conservatism during those periods. You cannot fire yourself, so periods of suboptimal returns may cause you to rethink your strategy but won’t see you jobless or (unless you leveraged) penniless.

Don’t hire a financial adviser, therefore. Learn to manage money yourself. Buy index funds if you don’t have a strong idiosyncratic view and keep a substantial portion in cash or short-term bonds. Managing your own money is easier than you think, managing other people’s may well be impossible.

And who’s outperforming the market, the inverse Cathie Wood? As I told my wonderful investment management professor Jay Light in class in 1973, it must be the little old ladies!

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)