Don't Rely On These 'Professional' Investors

By definition, being a "professional" means your level of expertise is greater than that of amateurs. It would be surprising if professional golfer Phil Mickelson routinely posted lower scores than the average weekend player. Do you really believe the tennis champion at your local club would make a credible showing against any of the top players on the tour?

It may appear counterintuitive, but this definition of "professional" does not hold up in the world of investing. "Professional investors" routinely underperform amateur investors, who simply buy an index fund designed to track a broad market index. Once you have an understanding of why this is true, it should fundamentally change the way you invest.

The dismal track record of mutual funds. Fund managers responsible for overseeing assets entrusted to them in mutual funds are the quintessential "investment professionals." They are devoted full-time to trying to beat their designated index. They have meaningful resources at their disposal. Brokerage firms provide them with reams of research, in an effort to win their trading business. They have great incentives to succeed because their compensation (and perhaps their continued employment) may depend on their ability to beat the returns of the appropriate index.

The performance of these professionally run funds is shockingly poor. Over almost any five-year period, 25 percent of actively managed funds will go out of business. Of the balance, 25 percent will outperform their benchmark, 25 percent will underperform modestly and 25 percent will underperform significantly, according to Rick Ferri's personal blog post, "3-to-1 Odds Favor Index Investors," which reflected on the S&P Indices Versus Active Funds (SPIVA) U.S. Scorecard. Over longer time periods, the track record of actively managed funds worsens.

Hedge fund superstars. Much has been written about the dismal track record of the average hedge fund over the past decade. The historical performance of hedge funds has been even worse than the underperformance of mutual funds. A 2003 study published in the Journal of Financial and Quantitative Analysis by Gaurav Amin and Harry Kat, examined the fee-adjusted returns of 77 hedge funds between 1990 and 2000. More than 90 percent underperformed their benchmark.

But how did the "best of the best" hedge fund managers perform in 2014?

Meredith Whitney. Meredith Whitney would certainly be considered one of the best-known investment professionals in the U.S. She gained considerable fame during the financial crisis for correctly predicting Citigroup's dividend cut. Subsequently, her crystal ball became clouded. In a December 2010 episode of "60 Minutes," she predicted hundreds of billions of dollars of municipal bond defaults. These defaults never occurred.

Whitney runs a hedge fund, American Revival Fund LP. According to a Dec. 22 Bloomberg article, "her fund is down 11% this year through last month, its main investor has demanded money back, top executives have left and her full-floor Madison Avenue office is now on the market."

During the same time period, the Standard & Poor's 500 index returned about 12 percent.

John Paulson. John Paulson was anointed a stock market "guru" of the highest order, based on a 2007 trade that netted him billions by betting against subprime mortgages. Many regard this trade as one of the greatest in stock market history.

It's not surprising that investors flocked to his hedge fund firm, with the expectation that Paulson had the ability to replicate this stellar performance. His recent track record must have disappointed them.

In 2014, Paulson's Event Fund (which has about $19 billion in assets) lost 27 percent year-to date, according to a Dec. 8 ValueWalk article. His Advantage Plus Fund is down 14 percent and his Recovery Fund has lost 6 percent.

Think about those negative returns for a moment. A person generally regarded as one of the greatest traders in the U.S. has incurred massive losses, while the S&P 500 index returned almost 12 percent. Who is the professional and who is the amateur?

Michael Aronstein. On Jan. 6, Morningstar announced its nominees for the 2013 U.S. fund manager of the year award. One of the three nominees for "alternatives fund manager of the year" was Aronstein, manager of the MainStay Marketfield Fund.

In announcing these nominees, Scott Burns, Morningstar's global director of fund research, says, "We have an esteemed list of nominees for this year's awards, filled with fund managers who have adeptly steered shareholder capital and outperformed their peers over the long term, in addition to attaining strong returns in 2013."

Let's fast-forward to the end of this year.

Aronstein's fund lost almost $3.7 billion in assets so far during 2014. The fund declined 10 percent this year, according to a Nov.12 Bloomberg article, "in part because of wrong-way wagers on the economic recovery, Aronstein said."

Here's the takeaway from this information: If you are relying on " investment professionals" who claim to have the ability to "beat the market," which includes most brokers and almost all actively managed mutual funds, you are an investing amateur.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read.