Academic research as well as history has shown that capital markets work. What we mean by that is that capital markets provide positive returns and process information and attract capital very efficiently.
Traditional investment management assumes by its very nature that markets are inefficient, that by laborious research and analysis one can predict the movement of the market, an asset class, or a security.
The evidence of active manager performance contradicts this notion. While investors can exhibit irrational behavior, this is known only after the fact and cannot be exploited consistently before it occurs.
There is no free lunch. Higher than risk-free returns require one to assume certain risks, mainly the unpredictable short term returns of investments. The higher the potential return, the less the returns are predictable in the short run.
However, given enough time, the predictability of higher returns increase, and the additional risk can be justified.
Certain risks are not justified, because they do not increase the expected return above that of the market. Examples of these types of risks are concentrated stock, concentrated asset classes, market timing, and active security selection.
In addition, to increasing uncompensated risks, they increase trading costs and taxes for taxable investors which lowers the expected return.
The exposure to certain markets risks explains approximately 90% of the performance of a portfolio. These risks are usually defined in terms of asset classes, such as large capitalization stocks, small cap stocks, bonds, money markets, etc. All the other factors such as market timing and security selection only account for a small part of performance.
Consequently, we focus on the factors that contribute the most to performance. Also, certain factors have provided “out-performance” historically. Exposure to value and small cap stocks typically have higher risks associated with them and have provided higher returns than the S&P 500 over time.