I attended a large foundation’s investment committee meeting the other day to learn about their investment strategy. One of the managers they utilize for large cap U.S. stock investments was there to talk about their methodology for achieving better returns over time than standard market benchmarks such as the S&P 500. In brief, they explained that they identify companies that the market undervalues and invest in a select few. This struck me as a very illogical way to invest.

It’s certainly possible to find large U.S. companies whose stock price – based on key business performance measures – has been relatively low as compared to market averages. But while those stocks may be truly low-valued, it is anybody’s guess as to whether or not they are undervalued. The rigorous data-driven process the manager described may convince them that they’ve found a stock that they would expect to grow faster than other large cap stocks. But think about what it would take to make that actually happen. First, other market investors would have to wake up one day and come to the same conclusion. Then they would have to start buying more shares of this stock as compared to other stocks in the benchmark, since that’s the only way to drive up its price and generate higher returns. And this would all have to occur after the investment manager purchased the stock, otherwise the price advantage would have disappeared before the manager could act.

Which brings me back to the original question: why would anyone want to beat the market in the first place? If the foundation were to simply invest in an index fund instead of using this particular manager, they would be certain to get market returns. There are even publicly-traded funds that have been able to beat the indices a bit through trading efficiencies and other tricks.

The other consideration is risk. In order to try to generate a higher return in any investment, you have to accept a higher degree of volatility. And the relationship is not linear. To target an additional 0.5% return, for example, could result in an increase in volatility of 25% or even higher depending on market conditions. In other words, the actual return you get could be much less that the benchmark. Since no one has control over returns, wouldn’t it make more sense to focus on risk management instead?

To their credit, the foundation made it clear that their investment strategy does properly involve diversification to mitigate overall portfolio risk. But they pride themselves on doing a good job of manager selection. I don’t see the value of spending time trying to evaluate and select managers whose methodology is based on trying to beat the market. Research from Dimensional Fund Advisors and Oppenheimer using standard statistical tools suggests that it would take upwards of 40 years to determine if a manager who has consistently beaten the market has done so through skill or through luck. None of the foundation’s investment committee members are likely to be around that long.