No, it has not suddenly become easier to beat the market.
Keep that in mind as you come across recent arguments to the contrary. It’s always tempting to believe you can beat the market in your 401(k)s, IRAs, and other retirement portfolios. But this temptation becomes irresistible when—recent data suggest—well more than half of actively managed funds and ETFs are beating their benchmarks.
The report published by Morningstar finds that 57% of actively managed funds and ETFs beat their benchmarks in the first half of 2023. Some specific style categories did especially well: Morningstar calculates that 74.7% of funds/ETFs in the “U.S. Small Blend” category—nearly three out of four—beat their benchmarks. These percentages are far higher than what we have become used to over the years.
However, the true picture is less optimistic. While it is true that some active managers are beating the market, it must be the case that another group is lagging. Once transaction costs are considered, the average market-weighted return of all active managers must be below the return of the market as a whole.
So, despite these recent findings, it is not easier to beat the market.
This argument was originally presented by William Sharpe, the 1990 Nobel laureate in economics, in a seminal article published in 1991. Sharpe showed that active managers, on average, must lag broad market indexes. He demonstrated that this conclusion depends “only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”
Sharpe’s analysis counters the many arguments being made about why so many funds and ETFs have beaten the market this year. One argument suggests that index funds have become so popular that the stock market has become less efficient and thus easier to beat. Another argument is that managers are now smarter and more sophisticated. Still, others assert that artificial intelligence is enabling everyone to beat the market.
While there may be individual managers who outperform the market, beating the market is a zero-sum game before transaction costs and a negative-sum game after transaction costs. Thus, for every active manager who comes out ahead, another active manager must be lagging. That’s why the percentage of large-cap growth funds beating their benchmarks averages well below 50%.
Given what I’ve learned from my 40+ years in this business, I doubt many of you will be persuaded by Sharpe’s argument and will instead continue to believe the odds are in your favor when trying to beat the market. One good solution, which recognizes both Sharpe’s argument and the psychological reality that you probably believe you’re above average, was proposed decades ago by Harry Browne, editor of a newsletter called Harry Browne’s Special Reports.
Browne advised creating two separate portfolios—one Permanent and one Speculative. The former would contain the bulk of your assets and be invested in index funds and held for the long term with little or no change. The Speculative portfolio would contain your play money in which you try your hardest to beat the market.
Browne’s advice is shrewd because it recognizes both the arithmetic truth of Sharpe’s argument and the psychological reality that you probably believe you’re above average. By structuring your portfolios correctly, you’re not risking your retirement financial security by trying to beat the market—and (almost certainly) lagging the market over the long term. But with your Speculative portfolio, you get to indulge that part of your psyche that believes you’re above average.
There will be times, like this year for actively managed mutual funds and ETFs, when your Speculative portfolio will outperform your Permanent one. However, over the long term, the latter will likely come out ahead. But, provided you structure your two portfolios correctly, there’s no harm in trying to prove me wrong.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org.