Chapter 16. Ask Yourself: Can My Equity Fund Manager Really Beat Your Equity Fund Manager?
| Tell the truth: You bought that mutual fund you are holding because of its perceived performance. Someone recommended it to you, or you read about its strong performance in the popular press. Nothing makes investors happier than the arrival of their mutual fund statement trumpeting the brilliant performance of the fund. You immediately ask yourself how much better off you are this quarter than you were the last. So much of what investors are exposed to about mutual fund performance is misleading, transitory , or simply useless. For example, in the first few months of 2001 a few mutual funds bought gold-mining stocks just as they gained an average of 25 percent in a short period. The performance of these funds received a positive boost, but this does not mean that one would want to hold gold stocks very often. These stocks experienced a down market for the preceding five years , and over the long run, owning gold and gold-mining stocks has been a very poor investment. What are the actual facts about performance? Do many funds outperform the market regularly? Does good performance, or bad performance, persist for several years? Of those funds that do perform well, are you likely to be able to select one? This chapter and the next one shed some light on these issues. We all look for shortcuts ”clear, quick advice ”in our busy lives. Consumer Reports rates potential purchases for us, such as cars and refrigerators. College football and basketball polls purport to tell us the best teams on a weekly basis. Plenty of Web sites rank vendors and products. The same is true with mutual funds. As we saw in an earlier chapter, Morningstar developed a rating system for funds based on stars, with five stars being the best rating available. Investors can take a quick look and see if a fund they are interested in carries five stars, or at least four. This system is now well established, dating back to 1985. A majority of the money going into mutual funds is invested in those funds carrying a rating of either five stars or four stars. There is no doubt that these Morningstar ratings have been influential on investor behavior. In fact, according to a large-scale study of funds during the late 1990s, Morningstar ratings clearly affect the flow of money into various funds. [1] Based on a change in the star ratings, the flow of money could be influenced in either direction. Once eligible to be rated, an unranked fund that achieved a five-star rating could expect 50 percent more in assets than would be achieved otherwise .
Other things equal, this rating system should be useful advice in deciding on a fund to buy. It is both a useful and a legitimate attempt to convey information in a standard format that is instantly recognizable and internally consistent. Morningstar does its best in producing such ratings, but what can they really show? These ratings are one piece of information, and as such can be useful. However, they tend to be used by many investors as a powerful screening tool in selecting funds to be owned into the future. Ratings can be very misleading for sector funds because they really reflect the fact that a particular sector was hot for a particular period of time. The same sector can easily cool off in the future. Therefore, a sector fund could receive a five-star rating based on that particular sector having been very popular, and investors could react to that five-star rating just as overall interest in that sector is starting to wane. In other words, the rating leads you to the fund at its cyclical peak.
If investors are not likely to choose a mutual fund that will outperform the market over time, why do so many keep trying? You have only to look at the action when a hot fund is identified in the press, as new money flows into it at a rapid rate. A Fortune article on Vanguard shareholders made the following point, which summarizes the situation nicely . The article noted that despite knowing about the advantages of index funds, many investors ignore the low probability of earning large returns "because they believe the laws of investing don't apply to them. They pile into hot stocks (Cisco, anyone ?); they load up on glitzy mutual funds ("beat the market three years running!"); and they buy bonds from their brokers ("I don't know what it is, honey") for their kids ' college education. All in a quixotic quest for outperformance." [3]
Your rebuttal might be along the following lines: "Clearly, some funds outperform the market, as well as their peers, each year. It makes sense to go with the winners, who have the hot hand. Just as clearly, some funds seem to be more or less persistent underachievers. It makes sense to avoid those funds at all costs." If you are thinking along these lines, there is substantial evidence that could dissuade you, as we will see later. In the meantime, here is an interesting finding that is suggestive of what you can expect as you start to untangle the performance puzzle. It is but one example of many that can be cited when we start discussing the performance of mutual fund managers. Morningstar confers the title of Manager of the Year on three managers (prior to 1996, there was only one winner per year). This award is based on outstanding total return for the prior 12 months in addition to longer term evidence of consistency. Bloomberg Personal Finance examined the performance of each of the 23 winners between 1987 and 1999. [4] This analysis compared the performance for the year the manager won with subsequent performance. Of the 23 winners, 16 saw their performance decline substantially in the following year. In the case of 12 of these managers, the fund's decline was approximately 50 percent from the peaks the year before.
Morningstar's senior editorial analyst noted the following with regard to these findings: "You win the award because you're on top of your game. But a sector doesn't run hot for long. The environment quickly changes, and your winning streak is over." [5]
Let's consider the technology story in more detail. At the end of 1999, the technology funds were clearly the place to have been; the average return for the year for this group of funds was an unbelievable 136 percent, six times the performance of the market as a whole. Of course, many of the technology funds earned five-star ratings from Morningstar. The usual happened: Money poured into this sector. In the first quarter of 2000, some $34 billion was invested, more than for any other sector that quarter. What happened next? For the 12 months ended March 31, 2001, the average technology fund lost 62 percent. A $10,000 investment in technology over the year was worth about $3,840 on that date. This is clearly not getting rich quick! Figures such as this suggest that much of mutual fund investing is a sucker's bet. The pursuit of funds that have performed well in the past ultimately leads to disappointment. Here is another set of sobering figures, taken from a 2002 fund survey in Forbes magazine. [6] The article noted that there were 3,115 U.S. funds at that point in time that buy and hold primarily domestic stocks (therefore, we are not considering international funds in this discussion). Of these, only 523 had been around for 15 years. Right off the top, we can't assume good performance over a substantial time period because most of these funds have not been in existence for that many years.
Of the 523 funds with a 15-year history, only 130 outperformed the Vanguard 500 Index Fund over the 15-year period. Think about that: Over the most recent 15-year period as of early 2002, only 130 funds out of 3,115 then in existence outperformed an index fund that required no actions on the part of the portfolio manager or anything from the investor other than a buy-and-hold strategy.
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