BENCHMARK
3. THE BENCHMARK
Let’s recap what the project has achieved so far. We designed a protocol which has been tested across four diverse market types (indices, commodities, precious metals and cryptocurrencies) over the maximum quantity of available data for each market. Models were built using different amounts of model data and tested on holdout data across all markets. While this is a broad-brush approach, it tells us whether our methodology has general validity. Then, by designing a custom algorithm to combine trend analysis with momentum analysis, we improved performance still further and now have a general approach which appears promising, and exhibits consistency across a variety of markets, time periods and market conditions. The next important stage will be to take this general approach, and use it to build a full model for a specific market and then test it under real-world trading conditions to see how it would have performed throughout history. Before we do that however, there’s one important step that we must take, and that’s to select a performance benchmark to compare against our results.
THE ADVANTAGES OF USING 'BUY AND HOLD' AS A BENCHMARK
SIMPLICITY AND UNDERSTANDABILITY
Firstly, the 'buy and hold' strategy is straightforward and easy to understand. It involves buying a security and holding it for a long period, regardless of market fluctuations. It provides a clear and uncomplicated baseline for comparison
LONG-TERM PERFORMANCE
If you’re prepared to invest for the long term, then 'Buy and hold' is hard to beat, and it provides a good way to compare a simple, passive strategy, with a more complex trading system. It helps establish if the additional complexity and trading frequency of a system are justified by better returns.
MARKET CONDITION ADAPTABILITY
A robust trading system should ideally perform well across various market conditions, including bull, bear, and sideways markets. Comparing a system to 'buy and hold' over a multi-decade timespan can highlight its adaptability and effectiveness. Ideally, a system should outperform not just in terms of profit but also with less volatility.
WHAT’S THE EVIDENCE FOR BUY AND HOLD?
was surprised to find a substantial amount of research to support the hypothesis that a 'buy and hold' strategy often outperforms many actively managed funds over the long term.One of the most interesting is the SPIVA (S&P Indices Versus Active) reports, published by S&P Dow Jones Indices, which provide detailed comparisons between the performance of actively managed funds and their benchmarks. Key findings from recent SPIVA reports include:
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Consistent Underperformance: A significant majority of actively managed funds underperform their respective benchmarks over long-term periods.
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Persistence of Underperformance: This trend of underperformance is consistent across various fund categories, including large-cap, mid-cap, and small-cap funds.
For instance, the SPIVA U.S. Year-End 2023 report showed that:
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Over a 5-year period, 90% of actively managed European funds performed worse than their respective benchmarks.
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Over the same period, 79% of US funds and 93% of Canadian funds underperformed their benchmarks.
In addition to the empirical evidence from the SPIVA reports, there are also detailed studies from Vanguard and Dalbar, as well as lots of academic research which support the hypothesis that a 'buy and hold' strategy is more effective than many actively managed funds over the long term.
This effectiveness is attributed to a number of things including lower costs, tax efficiency, reduced behavioral biases, and the general upward trend of the market over time.
THE PROBLEM WITH FUND MANAGERS
It does seem that many professional fund managers are not as good as they should be and certainly don’t deserve their high fees. Whether this is down to hubris, it’s hard to say, but if you can’t consistently outperform ‘buy and hold’ then you probably shouldn’t be doing it.
There have been a number of recent high-profile UK fund managers whose approaches did not stand the test of time with disastrous result for investors.
Neil Woodford
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Woodford Equity Income Fund: The trouble began when his flagship Woodford Equity Income Fund experienced significant underperformance. Woodford had made large bets on illiquid, small-cap stocks, which became difficult to sell as investors began pulling out their money.
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Suspension and Collapse: In June 2019, the fund was suspended, preventing investors from withdrawing their money. This led to a huge loss of confidence and eventually, in October 2019, the fund was closed, with investors suffering significant losses.
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Aftermath: Woodford's reputation was severely damaged, and his investment firm, Woodford Investment Management, was closed down.
Crispin Odey
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Odey European Inc. Fund: Odey's flagship fund, the Odey European Inc. Fund, suffered heavy losses in recent years. In 2020, the fund lost around 30% of its value due to wrong-way bets on market movements, particularly during the volatility induced by the COVID-19 pandemic.
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Performance Issues: The fund has experienced poor performance over several years, leading to significant outflows and reducing its assets under management from its peak.
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Personal Controversy: Crispin Odey has also faced legal and personal controversies, further impacting the reputation and stability of his firm.
Mark Barnett
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Invesco Income and High Income Funds: These funds, managed by Barnett, faced significant outflows and underperformance. Like Woodford, Barnett's funds had high exposure to illiquid stocks, which became problematic during market downturns.
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Departure: In 2020, Barnett was removed from managing these funds, and the funds were restructured under new management. Investors in these funds experienced substantial losses.
Julian Robertson’s Protégés - Lansdowne Partners
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Lansdowne Developed Markets Fund: This flagship fund faced significant losses in recent years, particularly during the COVID-19 market turmoil. The fund, which had a long history of strong performance, saw declines due to wrong-way bets on certain sectors.
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Changes in Strategy: The firm announced it would close the Lansdowne Developed Markets Fund to external investors in 2020, a significant shift given its previous prominence.
CONCLUSION
Research shows that a simple, passive strategy such as ‘buy and hold’ is actually an excellent benchmark with which to compare system performance over an extended period of time. As the performance of the majority of actively managed funds demonstrates, it’s not easy to beat it.
With our benchmark established, now let’s select a market to test.