Why it is So Hard to Exceed Performance Benchmarks?

In the world of the financial markets, consistently outperforming established benchmarks such as the S&P 500 is a monumental task that eludes many. This is exemplified by the SPIVA report, which evaluates the performance of actively managed funds against their benchmarks worldwide, revealing that a staggering 75% to 90% of funds fall short over extended periods. This prevalent underachievement raises critical inquiries about the inherent difficulties in surpassing market benchmarks. Despite possessing advanced skills and knowledge, even seasoned Fund Managers often struggle to eclipse these benchmarks. The reasons behind this phenomenon warrant a deeper exploration.

To understand this conundrum, it’s essential to delve into the mechanics of how averages operate within the context of financial indices and the performance of individual Fund Managers over time. Consider the S&P 500 index, a barometer of the total value and market capitalization of its constituent companies. At first glance, it might appear feasible for a well-informed fund manager to outmanoeuvre this average through strategic investment choices. However, the situation is significantly more complex.

The value of an index at any given moment is a snapshot that encapsulates the collective decisions of all market participants at that time, analogous to how the market price of a commodity, such as cocoa, is determined by the aggregate of buying and selling activities. It’s said that the benchmark or price serves as a “fossilized record” of a specific moment, capturing the essence of those who have endured, rather than those who have faltered.

Drawing a parallel to a vast marathon with thousands of participants, if averages are calculated based on the entrants present at various checkpoints, these figures won’t accurately reflect the overall average across the event’s duration. Instead, they merely document those who have managed to persevere at that particular juncture. Numerous participants will inevitably fall by the wayside due to insurmountable challenges, causing the average to deviate progressively from the initial average and ultimately represent only those who have survived to that point.

This distinction between the average performance of all participants at a single moment, as depicted by an index, and the average performance of an individual participant over time is a key factor in the difficulty Fund Managers face in outperforming benchmarks. To fully grasp this concept, it’s necessary to consider multiple temporal snapshots. These averages evolve, reflecting varying levels of market participation and the influence of traders’ decisions (to buy or sell) at those times. Financial markets are dynamic, characterized by phases of predictability, randomness, and uncertainty, all of which profoundly affect the averages at any given moment. It’s crucial to acknowledge that market participation is fluid, with new entrants and exits reshaping the landscape over time.

The non-ergodic nature of financial markets plays a pivotal role in this context. In such environments, the long-term experiences of an individual investor do not align with the collective experiences of many participants at a single point in time. Market conditions are subject to wide-ranging fluctuations over time, diverging from the static snapshot presented by an index at any given moment.

For example, a trader who excels in the market for a decade represents a small minority; the vast majority of traders (approximately 90%) withdraw within such time frames, leaving a mere 10% to influence current market prices. This high turnover rate implies that the average performance observed at any given moment does not encapsulate the long-term experiences of those who have exited the market.

Additionally, traders who remain active and navigate the “risk of ruin” successfully can see their returns compound over time, assuming they adapt to evolving market conditions. Conversely, a trader who exits the market ceases to affect future market dynamics and forfeits the opportunity for potential returns.

The challenge of consistently exceeding market benchmarks lies in the fundamental difference between the aggregated market performance at any instant and the sustained individual performance of market participants over time. This discrepancy, coupled with the dynamic and unpredictable nature of financial markets, renders the task of outperforming these benchmarks a formidable endeavour for traders and fund managers alike.

Confronted with the persistent issue of underperformance, even among adept market participants, one might wonder how it is possible to outdo these industry standards. The essence of achieving superior returns over an extended period is encapsulated in the principle of ‘survival.’ A trader who weathers the market’s fluctuations and remains active is better positioned to leverage advantageous moments that arise.

The focus should shift from the relentless pursuit of higher yields to the strategic avoidance of severe losses that could compromise long-term investment objectives. Hence, the key lies in emphasizing endurance over the pursuit of extraordinary gains. Higher returns are invariably linked with higher risks, particularly when magnified by the use of leverage. To ensure a lasting presence in the market, it is imperative to balance expectations of returns with the use of leverage judiciously.

The irony resides in the fact that enduring through numerous transactions necessitates prudent risk management, which might lead to reduced leverage and modest gains per transaction. Yet, over the span of thousands of transactions, these conservative gains, when compounded, can culminate in returns that surpass market benchmarks.

Suffering a significant loss or encountering a profound market downturn can severely impede the compounding of wealth over time, rendering such setbacks almost insurmountable. These unrecoverable losses not only eliminate the possibility of further market engagement but also arrest any prospects for future financial growth. Therefore, in the realm of investing, the art of survival through calculated risk management and the judicious use of leverage becomes the cornerstone for achieving long-term success and outpacing market benchmarks.

When we delve into strategies for enduring success in financial markets, the concept of the geometric average, particularly illustrated by the Compound Average Growth Rate (CAGR), becomes pivotal. Unlike simple averages, the geometric average accounts for the cumulative effect of compounding returns over time, highlighting the importance of the return sequence. This path-dependent nature of the geometric average underscores how the order and magnitude of returns can significantly influence the overall growth of an investment.

This approach to averaging underscores the importance of a disciplined strategy in managing and mitigating risks within a portfolio, while simultaneously nurturing the growth of profits. Such a method can carve a trajectory of returns that substantially amplifies the power of compounding. It’s about creating a favourable environment where the positive effects of compounding are not just maintained but actively enhanced through strategic decisions.

Investors and traders who adopt methodologies focused on swiftly mitigating losses, broad diversification to lessen the blow from any singular setback, and seizing opportunities that present substantial growth potential, can foster a series of returns with beneficial geometric qualities. By prioritizing these strategies, they can harness the full potential of compounding, which is instrumental in achieving superior long-term growth.

Trend-following traders serve as a prime example of this approach in action. They implement strategies that capitalize on the long-term trends in the market, allowing them to remain engaged over extended periods. This sustained participation, coupled with the strategic use of compounding, enables them to generate returns that not only outstrip traditional benchmarks but also eclipse the general market performance. This method underscores the synergy between strategic risk management, the exploitation of market trends, and the judicious use of compounding, illustrating a comprehensive blueprint for long-term financial prosperity in the unpredictable terrain of the market.

The TTU TF Index distinguishes itself remarkably in terms of performance when juxtaposed with benchmarks such as the S&P 500 TR Index and the SG Trend Index, by delivering substantially higher returns (Refer to Figure 1). This notable outperformance can be attributed to its unique selection criteria, which necessitates a minimum track record of 15 years for inclusion. This contrasts sharply with indices like the SG Trend Index, where the emphasis is on the size of the Fund Manager (FM) rather than the durability of their performance history.

Figure 1: Comparative Performance of TTU TF Index, SG Trend Index and S&P500TR Index

Note: For more information about the TTU TF Index, refer to the monthly Trend Following Performance Reports prepared on Top Traders Unplugged in the Blog posts. https://www.toptradersunplugged.com/blog

The exceptional performance of the TTU TF Index is primarily a result of the compounding benefits accrued by its constituents, who have remained consistently active over the prolonged period. In contrast to other indices, which may experience performance dilution due to the inclusion and subsequent removal of underperforming entities, the TTU TF Index benefits from a consistent and stable lineup of constituents. For example, the SG Trend Index, which ranks the top ten trend followers based on assets under management, undergoes constituent changes driven by fluctuating performance levels, which in turn negatively impacts its long-term performance through a compounding effect.

The members of the TTU TF Index have demonstrated remarkable resilience across various market conditions, including those that are typically challenging for trend-following strategies. By minimizing losses, these trend followers have not only managed to persevere through tough times but have also secured a higher long-term average return compared to other indices.

This achievement highlights the significance of geometric returns associated with enduring market presence. The ability to consistently leverage favourable market conditions while maintaining a competitive advantage is crucial for harnessing the profound effects of compounding over time. Thus, the TTU TF Index serves as a testament to the strategic advantage of prioritizing long-term track record and stability, showcasing how such an approach can lead to superior long-term performance in the complex landscape of financial markets.

Emphasizing endurance in the realms of trading and investing invariably involves accepting certain compromises, particularly with respect to potential gains. To secure a lasting presence in the market, it’s crucial to exercise restraint in the use of leverage and to eschew the pursuit of high returns through aggressive strategies. This prudence stems from an acknowledgment of the financial markets’ volatile nature, marked by unpredictable cycles or regimes whose timing and characteristics are not foreseeable. The unpredictability and variability of these market phases demand a resilient strategy capable of enduring diverse market conditions over extended periods.

The non-ergodic nature of financial markets is a fundamental concept to grasp, signifying that the patterns and outcomes witnessed over time do not consistently mirror the conditions and results observed at any specific point. This divergence results from the evolving mix and behaviours of market participants. Unlike ergodic systems, which presuppose uniformity in market conditions and participant actions, the actual market landscape is in constant flux, with participants entering and exiting, thereby altering market dynamics and introducing both challenges and opportunities.

Against this backdrop, the relevance of time-based averaging becomes apparent. The market encompasses a broader array and diversity of participants over time than is apparent at any single instance. An ‘absorbing barrier,’ such as a significant loss compelling a participant’s exit from the market, can preclude future participation, thus impacting the market’s long-term structure and dynamics. This underscores the necessity of adapting to shifting regimes and managing the risks tied to a mutable market landscape.

Trend Followers exemplify the ethos of valuing longevity. Their foremost aim is to maintain an active market presence, which positions them to leverage forthcoming opportunities and harness the power of compounded returns over time. Their strategy is intrinsically oriented towards the long-term, adopting a ‘barbell’ tactic that meticulously mitigates risk on one end to avert devastating losses, while on the other end, aiming to seize significant profits from clear market movements. This equilibrium enables Trend Followers to traverse a spectrum of market conditions, safeguarding their ongoing engagement and the prospect of achieving returns that exceed the average over time.

In summary, financial markets defy the ergodic hypothesis, where the aggregate long-term outcomes would reflect the individual experience of an investor or Fund Manager. Instead, markets are defined by their conditional probabilities and the influence of extreme, or ‘fat-tailed,’ events that can markedly alter outcomes from the average, leading to trajectories that significantly diverge from the anticipated average return.

Trade well and Prosper