Burton Malkiel

"I have become increasingly convinced that the past records of mutual fund managers are essentially worthless in predicting future success. The few examples of consistently superior performance occur no more frequently than can be expected by chance."

— Burton Malkiel, A Random Walk Down Wall Street, 1973

"You will almost never find a fund manager who can repeatedly beat the market. It is better to invest in an indexed fund that promises a market return but with significantly lower fees."

— The Economist, July 3, 2003, "The Blame Game", John C. Bogle, The Little Book on Common Sense Investing, 2007

Ron Ross

"Wall Street's favorite scam is pretending that luck is skill."

— Ron Ross, The Unbeatable Market, 2002

Russel Wermers

"The number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can't eliminate the possibility that the few that did were merely false positives."

— Russell Wermers, as quoted in "The Prescient are Few", New York Times, July 13, 2008


Caddyshack II, Batman & Robin, The Godfather III… all of these movies have one thing in common: they all were abysmal sequels to blockbuster movies. We long to regenerate scenarios when everything comes together perfectly and the stars align, but that kind of success is rarely duplicated. In the world of money managers, success means blockbuster performance… every year! Managers who are successful in the short term are considered the current financial heroes, despite the fact that every reputable study of mutual fund performance over the past 30 years has found there is no reliable way to know if managers with winning performance in the past will win again in the future. This is why some variation of the disclaimer "past performance is no guarantee of future results" must appear in all mutual fund advertisements and prospectuses. Even still, unwitting investors select these managers to handle their portfolios, and the dangerous practice of manager picking begins.

Sometimes managers can duplicate their success a few years in a row, but it just doesn't last. At least with movies, the directors are somewhat in control of the elements that are used in creating their sequels. Money managers have no such control over the news that drives the markets. As hard as it is to duplicate success in the film world, it is even more difficult for these all-star money managers to duplicate their past success.


Track Record Investing

"Most investors follow the crowd down the path to comfortable mediocrity," says David Swensen in Pioneering Portfolio Management.1 Anxious to capture the financial gains that come with a winning mutual fund manager, manager pickers blindly chase the hot performing mutual fund manager's recent track record, failing to realize their odds for future success have vastly diminished.

Figure 5-1 shows the results of a study using Morningstar data reflecting the performance of active fund managers for the 16 years from 1998 to 2013. The chart depicts how an average of only 7.8% of the top 100 fund managers repeated their performance the following year. In the years 2000, 2008 and 2009, none of them repeated their previous year’s top 100 performance.

Figure 5-1

Pick Your Manager
Pick Your Manager

These variations in manager performance are a function of luck and the random rotation of the style of their fund. When a particular manager’s investment style is rewarded by the market, that manager is often credited with brilliance and skill. As market conditions change, however, so does the performance of fund managers. Figures 5-2 and 5-3 track the rankings of the top 10 mutual fund managers in a given year and subsequent time periods. These charts reveal how quickly a “top” fund manager can slide to the bottom. For example, Figure 5-3 shows that the Rydex Dyn Inv had the highest performance out of 5,376 mutual funds in 2008. In 2009, however, the fund slipped to 5,736th place. Investors found themselves at the bottom in 2012 when the fund slipped to 6,721 out of 6,738. The data contained in these two figures reveal many other examples of fund performance that sharply declined.  

As Bob Dylan said, "the first ones now will later be last, for the times they are a changin."2

Figure 5-2

Figure 5-3

An analysis of the Morningstar database of 245 mutual funds with 10 years of returns is shown in Figure 5-4. The top graph shows the performance rankings of these 245 funds from best to worst (left to right) for the first 5-year period from 2003 to 2007. Then the same order of fund rankings is maintained in the bottom graph in order to see if fund performance was repeated in the years 2008 to 2012. Based on the above studies, it should come as no surprise that many of the managers who outperformed their peers in the first 5-year period did not do so in the second 5-year period, and vice versa.

Figure 5-4

Another tracking mechanism that can cause confusion is the reporting of mutual fund returns, often inflated when compared to actual long-term returns. The discrepancy arises from neglecting to account for funds that have closed or merged, resulting in the higher average returns of only surviving funds included in calculations. When funds go under, their records are stricken from databases, creating a survivorship bias. This bias inflates the remaining funds' average returns by 19% of the return, according to the Center for Research on Securities Prices (CRSP). Out of the 50,611 mutual funds in CRSP’s database from 1962 through June 30, 2012, 21,622 of them were delisted—an astounding 43%.


The Fired Beat the Hired

Even large institutions and pension plans chase performance, much to their detriment. A study conducted by Amit Goyal of Emory University and Sunil Wahal of Arizona State University found that manager hiring and firing decisions made by consultants, board members and trustees were a waste of time and money.

The study, "The Selection and Termination of Investment Management Firms by Plan Sponsors,"3 reveals the negative impact of manager picking. Goyal and Wahal analyzed hiring and firing decisions made by approximately 3,700 plan sponsors, representing public and corporate pension plans, unions, foundations, and endowments. Figure 5-5 shows the results of hiring 8,755 managers over a 10-year period from 1994 through 2003. Note that investment manager performance is measured by average annualized excess returns over a benchmark. The chart illustrates that managers that were hired had outperformed their benchmarks by 2.91% over the three years before being hired. However, over the following three years the managers on average underperformed their benchmarks by 0.47% per year when adjusted for management fees and transition costs. Plan sponsors often proceeded to fire managers who had underperformed in favor of other recent top performers, only to repeat the cycle again. The study concluded, "In light of such large transaction costs and positive opportunity costs, our results suggest that the termination and selection of investment managers is an exercise that is costly to plan beneficiaries."

Figure 5-5

Using data from the same study by Goyal and Wahal, Figure 5-6 also conveys the tendency for investment committees or plan sponsors to hire investment managers with a history of above-benchmark returns and fire managers with lower performance. The chart shows that after managers were hired, their post-hiring excess returns were indistinguishable from zero, and the managers that were fired actually performed better than the hired managers. The plan sponsors should have just bought index funds and forgotten about manager picking in the first place.

Figure 5-6



In the 2009 edition of Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment,4 Yale Endowment Chief Financial Officer David Swensen states, "Active management strategies, whether in public markets or private, generally fail to meet investor expectations." However, "In spite of the daunting obstacles to active management success," he continues, "the overwhelming majority of market participants choose to play the loser's game."

Despite Swensen's admonition, active manager selection and termination remains a common practice among state and municipal pension plans. Plan sponsors rely on investment consultants to recommend fund managers whom they anticipate will deliver above benchmark returns. Because these consultants are paid to conduct searches for winning managers, they are inherently conflicted, likely finding it difficult to advise their clients to abandon the losing game of active management and opt instead for a passive portfolio. Might these consultants know too well that their presumed necessity would fade away once plan sponsors embrace the merits of lower-cost passive investing? As Upton Sinclair so keenly observed, "It is difficult to get a man to understand something when his salary depends upon his not understanding it."5

An investigative journalist for St. Petersburg Times, approached Index Fund Advisors (IFA) and a handful of other investment experts to collect some in-depth analysis of the risks and returns of the Florida State Pension Plan for various periods of time relative to various index portfolio strategies. The research results were revealed in a July 31, 2011 article titled, "Easy investments beat state's expert pension planners,"6 which concluded that a simple index portfolio would have outperformed the Florida state pension plan's investment performance over the last ten years.

"The professionally managed SBA [State Board of Administration] performed worse—by more than a percentage point—than seven index-fund portfolios for the decade ending Dec. 31, 2010," the article reports. "On average, a $100 investment in an index portfolio grew to $184, while Florida's pension delivered just $157," the reporter concluded.

The findings prompted further query for IFA. If Florida's $124 billion pension plan fared so poorly against the index portfolios, what about the other states? IFA has attempted to analyze the employee retirement systems in all 50 states. Data on over 40 state pension plans have been received to date, yielding similar results with varying degrees of underperformance relative to the index portfolios.

Figures 5-7 through 5-10 show the annual risk and return of various state pension plans, net of fees, compared to 7 passively managed index portfolios comprised of a blend of diversified asset allocations. A best effort was made to estimate fees in states that report returns before fees are deducted. States were analyzed for both 11 or 12-year periods and 24 or 25-year periods and were charted based on either a June 30th or December 31st year-end date. The data show only one state succeeded to outperform, albeit negligibly, relative to the index portfolios. For data sources, go to pension-gate.com.

Figure 5-7 7

Figure 5-8 8

Figure 5-9 9

Figure 5-10 10

Directors of these pension plans have access to so-called "top" money managers and investment consultants, which would lead one to believe that these plans fired their very best shots at earning above-benchmark returns, only to fall short. This analysis reveals that the widely implemented and costly process of using consultants to recommend the hiring and firing of investment managers for state pension plans has overwhelmingly delivered a negative payout relative to a risk-appropriate set of index benchmarks.



One solution to test the claim that a manager can beat a market is to identify if there are enough years of performance data to be statistically significant. A measurement called a t-stat of 2 or higher indicates a confidence level of at least 95% that the manager actually earned a return higher than his benchmark due to skill, with up to a 5% chance that it was due to luck. Figure 5-11 shows the formula to calculate the number of years needed for a t-stat of 2.

Figure 5-11

Step one is to determine the excess returns the manager earned above an appropriate benchmark. Step two is to determine the regularity of the excess returns by calculating the standard deviation of those returns. Based on these two numbers, it's easy to calculate how many years are needed to support the manager's claim.

Using the study previously shown in Figure 3-5 as an example, 207 mutual funds were compared to their risk-appropriate benchmarks over a 20-year period. Only 60 of the 207 fund managers had positive excess returns, and only two appeared to have skill (a t-stat of 2). But when the time period was extended back to their inception dates, the t-stat dropped below 2 for one of them, indicating that skill evaporated.

Of those 60 fund managers, the average excess return was 1.00% and the standard deviation was 5.82%. You can find the intersection of the average excess return (1.00%) and standard deviation (5.82%) in Figure 5-12, and then follow the line, concluding that 135 years of returns data are needed to establish skill as the reason for the higher returns. Obviously, no manager has ever managed a fund for 135 years; therefore, we are unable to accept the manager's claim.

Figure 5-12

In "Challenge to Judgment," Paul Samuelson dismisses investors who claim they can find benchmark-beating managers by saying, "They always claim that they know a man, a bank, or a fund that does do better. Alas, anecdotes are not science. And once Wharton School dissertations seek to quantify the performers, these have a tendency to evaporate into the air—or, at least, into statistically insignificant t-statistics."11

  • 1Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment (New York: The Free Press, 2000).
  • 2Bob Dylan, The Times They Are a-Changin', song, Columbia Studios, 1964.
  • 3Amit Goyal and Sunil Wahal, "The Selection and Termination of Investment Management Firms by Plan Sponsors," The Journal of Finance, vol. 63, no. 4 (2008).
  • 4Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment (New York: The Free Press, 2000).
  • 5Upton Sinclair, I, Candidate for Governor: And How I Got Licked (1935), ISBN 0-520-08198-6; repr. University of California Press, 1994, pg. 109.
  • 6Sydney P. Freedberg and Connie Humburg, "Easy Investments Beat State's Expert Pension Planners," St. Petersburg Times (St. Petersbug, FL), Jul. 31, 2011.
  • 7State Retirement Systems Data from public information, includes states that provided 10 and 23 yrs of returns for fiscal years ending 6/30, and are net of fees; Index Portfolios are net of fund fees and 0.05% Advisory Fee. See www.pension-gate.com/ states for additional disclosures.
  • 8Ibid.
  • 9State Retirement Systems Data from public information, includes states that provided 11 and 24 yrs. of returns for fiscal years ending 12/31, and are net of fees; Index Portfolios are net of fund fees and 0.05% Advisory Fee. See www.pension-gate.com/ for additional disclosures.
  • 10Ibid.
  • 11Paul Samuelson, The Journal of Portfolio Management, "Challenge to Judgment," 1974, 1.1:17-19.
step 5introductionmanager pickingdavid swensenmorningstarcenter for research on securities pricescrspamit goyalsunil wahalthe selection and termination of investment management firms by plan sponsorsstate pensionpaul samuelsont-statbenchmarkfund managerschallenge to judgment

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