What Mutual Funds Look Like Next to Their Benchmarks (Losers)

Posted by Alex Frey (@alexhfrey )

For a long-time, rational individual investing was done with mutual funds. There were just no other good options to cost-effectively accumulate a diversified portfolio of stocks and bonds from around the world. 

While times have changed significantly and there are now low-cost index funds and ETFs that are readily available, the majority of investor dollars continue to remain in the mutual fund format, with 11.6 trillion invested in mutual funds and only a bit more than 1 trillion in ETFs (source: Investment Company Institute 2012 Factbook). In this article, we will look at what investors in actively-managed mutual funds are really getting in return for their fees. 

Fund Managers Habitually Fail to Beat The Market

In a world where you can buy an index-fund or low-cost ETF from Vanguard for .1% of your assets or less and match the performance of a large market benchmark such as the S&P 500, the reason that you might rationally pay .8% or more to a professional mutual-fund manager is to "beat" the performance of that benchmark. The theory is that the fund manager and his analysts will be able to use their intelligence and research skills to select stocks that will go up faster than the overall market. 

Unfortunately a variety of evidence indicates that most fund managers fail to pick stocks any better than anyone else, and in fact significantly lose to the overall stock market after taking their fees into account. 

Standard & Poor's compiles an annual report showing the number of mutual funds that are able to earn higher returns than their benchmarks. In the latest five year period, about 70% of US stock funds failed to beat their benchmark, a fairly typical result. 

Over longer periods, this number is likely much higher, since there is little persistence in top mutual funds (see below). In his book, Common Sense on Mutual Funds, Jack Bogle tracked 258 surviving mutual-funds through the 1982-1998 period - only 12 outperformed the market in a statistically significant way. And of those 12, only three continued to outperform the market until 2009 - the rest either underperformed or folded.

Of course, if you were the lucky investor who picked the right three mutual funds out of 258 options in 1982, then you likely came out ahead. But as we will see below, finding the diamond in the rough is not so easy...

Buying Top Performing Funds is Not a Winning Strategy

Most studies show that there is little persistence in the returns of professional managers, meaning that the best performing mutual funds from one period do not tend to repeat their performance in the next period. 

A 2012 paper by USC professor (and former Goldman Sachs whiz) Mark Carhart showed that there is zero persistence in mutual fund returns after you strip out the momentum effect. So just buying the funds with the best past performance is not likely to be a winning strategy. 

One reason that the best performers of the past may be unlikely to repeat their feat is tthe institutional constraints that top mutual funds face. When a fund starts generating good performance numbers, many investors will put money into it, chasing performance. The largest mutual funds may accumulate tens of billions on dollars in assets under management. This can make it hard for them to build meaningful positions in smaller-size companies, the very companies that are likely to be the next Google's or Facebook's. For instance, a fund with $10 billion dollars in assets could only buy .1% of a $100 million company, since it is only legally allowed to own more than 10% of a company without getting a special exception. And even if the fund was able to accumulate a .1% position, it would be effectively limited by the trading volume in that security, since there might not be enough shares traded on a daily basis for it to get in or out very quickly. 

Mutual funds are also limited by the requirement that they provide "daily liquidity" to their fund holders, meaning they have to be able to handle any redemption requests, which can be costly and require them to keep a significant cash buffer or trade in very liquid securities. 

To make matters worse, there may be strong incentives for very top managers to move to hedge funds, where they can usually make more money. Top hedge funds are usually off limits to all but the wealthiest individual investors. 

The Role of Luck and Chance in the Markets

So if mutual-fund managers as a whole seem incapable of beating the markets, and if the top funds from one period tend not to repeat their performances, why does it still "seem like" there are superstars out there?

One reason might be that we are a bit fooled by randomness, to use the name of a popular book by author, thinker, and former hedge-fund manager Nassim Taleb. . 

A famous example given to show this is to imagine that there was a national coin-flipping tournament where only those that toss a heads advance to the next round. The "winner" of this tournament - the person with the longest consecutive streak of heads tosses - would certainly appear to be a "coin-flipping genius" who just has a knack for turning out heads on every flip. The winner might even come to believe in his or her professed talent, and perhaps even write a book explaining the "theory" that he or she used to accomplish this amazing feat. But of course it would all be blind, dumb luck, in reality. After all, someone has to win a national coin-flipping contest by definition, and in a country of a few hundred million people, the winner is guaranteed to be a statistical outlier. 

This is easy to see in the case of flipping coins, because we know that the underlying process is, for all effective purposes, totally random. There is just no way that somebody can be "skilled" at flipping a coin. While this is not obviously the case with picking stocks, the underlying level of randomness is much the same. If you measure the performance of 100 million people at picking stocks, one of them is mathematically guaranteed to rank first, and that person has very likely accumulated a great track record over that time. But it will be very hard to determine whether it is from skill or just luck. 

A 2010 paper by Nobel-Prize winning economists Eugene Fama and Ken French does some statistical wizardry to try to answer just that question for top mutual funds. While it is impossible to say whether any single fund obtained it's results from skill or luck, it is possible to look at the distributions of returns and see if there are more top-performing funds than would be expected by randomness alone. The authors conclude that the evidence shows that it is likely that there are mutual funds that possess enough skill to cover their fees, funds for which investors would rationally put money into. Unfortunately, these "winning funds" make up only 2% of mutual funds, and it would have been almost impossible for an investor to select them in advance. Most funds that have done well in the past have just gotten lucky. 

Of course none of this "proves" that everyone that has beaten the market has done so as a result of sheer luck. But it does provide grounds for being skeptical of drawing too many conclusions from a great track record alone.  

It's Hard to Make a Rational Case for Mutual Funds...

A rational read of the evidence seems to indicate that while there are some mutual funds somewhere that are likely run by skilled managers who will be more than capable of recovering their fees and more over the long-term, trying to pick these funds in advance is an incredibly difficult exercise that has a lot of downside and comparatively little upside. 

This might be one reason why the assets in index funds has gone from 6% of all mutual-fund assets to 16% of all assets over the last fifteen years (source: 2012 Investment Company Factbook, Figure 2.12)


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By Alex Frey