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Few Brokerage Firms Beat the Market Last Year

INTERMEDIATE LEVEL

"Only six of 16 major brokerage houses managed to beat the market with their stock recommendations last year, according to a quarterly study of Wall Street’s stock-picking prowess.

...The study, by the Wall Street Journal and Zacks Investment Research Inc. of Chicago, tracks the official recommended list at each of 16 firms in an effort to estimate how an investor would fare by holding every stock on the list.

. . . All figures include price changes and dividends. Starting in 1993, figures also include a 1% trading commission when a stock is added to or deleted from a recommended list." (WSJ, 2/8/96, p. C1)

Q. Using this information about the way the study was conducted, if a fund’s performance was calculated to be higher than the S&P 500 Index, does that necessarily mean that the fund beat the market?

A. Not necessarily! The article does not indicate at what price the recommendations were bought. If the Efficient Market Hypothesis (EMH) is true, i.e., stock markets are efficient, then market price would have adjusted to the new information way before an individual investor could have actually bought/sold the stock. Thus, an investor actually following the recommendation could have done worse than suggested by the study.

Q. Can you think of another reason why the number of firms that actually beat the market might even be smaller than five?

A. Portfolio theory suggests that you need to compare performance not based on actual return, but based on risk-adjusted return. Thus, if a portfolio has a beta (with respect to S&P 500 as the benchmark) greater than one, then, according to the Capital Asset Pricing Model (CAPM), such a portfolio should have an average return higher than the benchmark. Hence, with regard to the recommendations that resulted in higher return than the S&P 500, the constructed portfolio might have also had a higher beta risk. If this were the case, then they would not have outperformed the benchmark once portfolio risk is also taken into account.

Note, however, that in practice, the relationship between beta and actual return need not hold precisely. The beta used in testing is only an estimate of the relationship between an asset’s actual return and the actual return on a benchmark such as the S&P 500 index. If the estimate is not precise (has a large standard error), then the difference in performance gap between what should happen and what actually happens widens.