Chapter 17. Determine How You Will Know Who the Winner Is

Many academic studies about mutual fund performance have been done. The "early" studies (e.g., those done in the 1970s) found very little evidence of consistency in performance. In other words, historical results were of little value in explaining future results. Some later studies, done in the 1990s by well-respected researchers, found some evidence of persistence in performance.

Part of the problem with the performance issue in general is determining accurately how well all mutual funds have actually done over time. There are many comparisons made on a regular basis, yet many of these are fundamentally flawed.

A major flaw in most performance comparisons is survivorship bias . This refers to the fact that when the performance of a group of funds is measured over time, the results typically do not reflect the fact that several funds were terminated during that period, primarily for bad performance. Therefore, these results show the survivors during the period, and their results clearly overstate the reality for the entire group that existed because the bad performers are taken out of the picture.

Here is one example of survivorship bias. [1] Over a recent three-year period, domestic diversified small-cap funds that were actively managed numbered about 300. As a group, they outperformed the 13 index funds for this category. However, a number of these are likely to go out of business over time. From 1995 to the beginning of 2001, according to Morningstar, 227 small-cap funds went out of business.

[1] This information is based on HelpDesk, Mutual Funds , May 2001, p. 82.

If we look over a 10-year period, there were approximately 75 actively managed domestic diversified small-cap funds. For this longer period, only two small-cap index funds were in existence. The actively managed funds outperformed the two index funds by an average of 0.1 percent, hardly a strong case for active management.

A study in the late 1990s, by Carhart in The Journal of Finance , sorted out many of the problems inherent in other studies, and we consider several findings from this study at various points. [2]

[2] See Mark M. Carhart, "On Persistence in Mutual Fund Performance," The Journal of Finance , March 1997, pp. 57 “82.

Carhart studied all known diversified equity funds from 1962 through 1993, thereby avoiding the survivorship bias that can, and has, affected other studies. Carhart concluded, "This article offers only very slight evidence consistent with skilled or informed mutual funds managers . Although the top-decile mutual funds earn back their investment costs, most funds underperform by amount the magnitude of their investment expenses."

It is easy enough to cite numerous statistics indicating that actively managed funds do not perform all that well relative to an appropriate benchmark ”a market index, their peer group, or sometimes what money would have earned in a conservative investment. Consider the following observations.

For the three-year period ending in July 2001, the average diversified stock fund was up 4.9 percent for the entire period, whereas the S&P 500 was up 9.6 percent. A more refined and accurate analysis would say this is not an entirely fair comparison because at least some of the funds in this group held some small stocks and some midcap stocks. Therefore, let's refine this analysis and do a closer match using mutual fund categories as defined by Lipper. [3] If we consider only those funds that more closely correlate with the S&P 500 Index, this group was up 6.4 percent for that period. Once again, the actively managed funds do not look good.

[3] Lipper, like Morningstar, provides data on mutual funds and its data can often be seen in The Wall Street Journal . In this example we are looking at the category of mutual funds Lipper calls "large-company core ."

Here is another example of the performance issue and why investors generally lose in pursuing performance. One of the great debates among investors is whether to purse growth stocks or value stocks. The same approach can be applied to funds: Should an investor concentrate on growth funds or value funds?

Measures are available of these two alternatives in the form of the Barra Large Cap Growth Index and the Barra Large Cap Value Index. Assume an investor switched between these two indexes each quarter based on buying the one that performed less well in the previous quarter. Since 1976, a strategy that did this would have performed slightly less well than a strategy that simply holds the S&P 500 Index. Once again, chasing performance does not pay off.

Let's next consider a really damaging piece of information that makes a significant case against actively managed mutual funds. As we noted previously, Vanguard is famous for its index funds, having pioneered them in 1976. The Vanguard 500 Index Fund is now the largest mutual fund in the world in terms of assets (although it has dueled with Fidelity's Magellan fund for this distinction, with each changing places periodically as first and second).

According to Vanguard, the complete record since 1976 is shown in Table 17-1.

Table 17-1. Average Annual Total Returns (Periods Ending June 30, 2001)
 

1 year

5 year

10 year

Since Inception

Vanguard 500 Index Fund

“14.85%

14.45%

15.00%

14.05%

Average general equity fund

“9.72%

12.82%

14.03%

13.84%

These figures summarize the situation well. Note that for the most recent one-year period, the average fund outperformed the index fund in that the loss was smaller. However, over time the effects of poor decisions, costs, and so forth take their toll. In each of the other comparisons, for five years, 10 years , and since 1976, the index fund outperformed the average general equity fund.

Does this mean that as an investor you cannot outperform an index fund? Of course not. For various periods of time, some funds will outperform the index fund, but you should ask yourself what the likelihood is that you will be holding those particular funds for the exact periods when the performance of the actively managed funds is superior .

Insights

Consider the odds of finding an equity mutual fund that will outperform the market over a period of several years. Consider the 10-year period from 1992 to 2001. According to Morningstar data involving 4,058 equity portfolios: [4]

  • Only 54 avoided losing money in any year.

  • Of those 54, only 31 beat the average annual return for the S&P 500 Index.

The bottom line is that you can own a fund that will outperform the market for a period of years, but the odds are heavily against you.

[4] This discussion is based on Virginia Munger Kahn, "The Few, the Proud, the Consistent Winners," The New York Times Web site, www.nytimes.com, April 10, 2002.

You should always remember that mutual fund managers and companies have a vested interest in the stories they tell. A popular story told in the 1990s goes like this. Index funds may be performing well now because the market is performing so strongly, but wait until the market goes down. When times get tough, the good stock pickers shine . They can drop the poorly performing stocks, and scoop up the ones with real promise. Meanwhile, the index funds will have to hold the underlying index, losers and all. Furthermore, index funds must stay fully invested in good times and in bad times, so when the market is down, actively managed funds will be able to take advantage and shift partly to cash.

This sounds like a plausible story, but what does the evidence show? One indication is what happened in 2001, when the market declined and most stocks and funds showed losses. Sure enough, the average equity index fund was down about 12.4 percent. This was a good opportunity for the actively managed funds to show their stuff, so how did they do? The comparable returns for actively managed funds was a decline of approximately 13.9 percent. The difference could be largely accounted for by the differences in annual operating expenses.

Finally, let's consider some cold hard evidence on mutual fund advertising. Such advertising is widespread in newspapers, magazines, direct mailings , and so forth. Jain and Wu did an extensive study of mutual fund advertising by equity mutual funds that advertised in Barron's or Money . [5] As one would reasonably expect, at the time of the advertisements the performance of the nearly 300 funds studied was good. Specifically, the one-year preadvertising performance was significantly superior to the performance of comparable benchmarks used in the study. What about afterwards?

[5] This discussion is based on Prem C. Jain and Joanna Shuang Wu, "Truth in Mutual Fund Advertising: Evidence on Future Performance and Fund Flows," The Journal of Finance , vol. LV, April 2000, pp. 937 “958.

For the postadvertisement period, the advertised funds, on average, significantly underperformed in comparison with the S&P 500 Index, the most popular measure of the market among mutual funds and other institutional investors. As Jain and Wu noted, there is much truth to the statement that mutual funds often make: Past performance does not guarantee future results. In short, there is no persistence to performance.

Jain and Wu went one step further and examined the flow of funds associated with these advertised mutual funds. Do advertised mutual funds attract significantly more money compared to funds in a control group with similar characteristics? Their results indicate that they do. Specifically, the influx of money to the advertised funds is about 20 percent larger than that for nonadvertised funds with similar characteristics.



Mutual Funds(c) Your Money, Your Choice... Take Control Now and Build Wealth Wisely 2002
Mutual Funds(c) Your Money, Your Choice... Take Control Now and Build Wealth Wisely 2002
ISBN: N/A
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Year: 2004
Pages: 94

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