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2019 Mutual Fund Landscape: Dimensional Fund Advisors

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Each year, Dimensional analyzes returns from a large sample of US-based mutual funds. Our objective is to assess the performance of mutual fund managers relative to benchmarks.*

This year’s study updates results through 2018. The evidence shows that a majority of fund managers in the sample failed to deliver benchmark-beating returns after costs.

We believe that the results of this research provide a strong case for relying on market prices when making investment decisions.

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*In the study results, “benchmark” refers to the primary prospectus benchmark used to evaluate the performance of each respective mutual fund in the sample where available. See Data Appendix for additional information.

 

Surveying the Landscape

The global financial markets process millions of trades worth hundreds of billions of dollars each day. These trades reflect the viewpoints of buyers and sellers who are investing their capital. Using these trades as inputs, the market functions as a powerful information-processing mechanism, aggregating vast amounts of dispersed information into prices and driving them toward fair value. Investors who attempt to outguess prices are pitting their knowledge against the collective wisdom of all market participants.

So, are investors better off relying on market prices or searching for mispriced securities?

Mutual fund industry performance offers one test of the market’s pricing power. If markets do not effectively incorporate information into securities prices, then opportunities may arise for professional managers to identify pricing “mistakes” and convert them into higher returns. In this scenario, we might expect to see many mutual funds outperforming benchmarks. But the evidence suggests otherwise.

Across thousands of funds covering a broad range of manager philosophies, objectives, and styles, a majority of the funds evaluated did not outperform benchmarks after costs. These findings suggest that investors can rely on market prices. Let’s consider the details.

Let’s consider the details.

 

Disappearing Funds

The size of the mutual fund landscape can obscure the fact that many funds disappear each year, often due to poor investment performance.

Investors may be surprised by how many mutual funds disappear over time. More than half of the equity and fixed income funds were no longer available after 20 years.

Including these non-surviving funds in the sample is an important part of assessing mutual fund performance because it offers a more complete view of the fund universe and possible outcomes at the time of fund selection. The evidence suggests that only a low percentage of funds in the original sample were “winners”—defined as those that both survived and outperformed benchmarks.

 

The Search for Persistence

 

Some investors select mutual funds based only on past returns. But sometimes good track records happen by chance, and short-term outperformance fails to repeat.

The exhibit shows that among funds ranked in the top quartile (25%) based on previous five-year returns, a minority also ranked in the top quartile of returns over the following five-year period. This lack of persistence casts further doubt on the ability of managers to consistently gain an informational advantage on the market.

Some fund managers might be better than others, but track records alone may not provide enough insight to identify management skill. Stock and bond returns contain a lot of noise, and impressive track records may result from good luck. The assumption that strong past performance will continue often proves faulty, leaving many investors disappointed.

 

The Impact of Costs

Why do so many funds underperform? A major factor is high costs, which reduce an investor’s net return and increase the hurdle for a fund to outperform.

All mutual funds incur costs. Some costs, such as expense ratios, are easily observed, while others, including trading costs, are more difficult to measure. The question is not whether investors must bear some costs, but whether the costs are reasonable and indicative of the value added by a fund manager’s decisions.

Let’s consider how one type of explicit cost—expense ratios—can impact fund performance. Our research shows that mutual funds with the highest expense ratios had the lowest rates of outperformance. Especially for longer horizons, the cost hurdle becomes too high for most funds to overcome.

High fees can contribute to underperformance because the higher a fund’s costs, the higher its return must be to outperform its benchmark. Therefore, investors may be able to increase the odds of a successful investment experience by avoiding funds with high expense ratios

 

Costly Turnover

 

Other activities can add substantially to a mutual fund’s overall cost burden. Equity trading costs, such as brokerage fees, bid-ask spreads,1 and price impact, can be just as large as a fund’s expense ratio. Trading costs are difficult to observe and measure. Nonetheless, they impact a fund’s return—and the higher these costs, the higher the outperformance hurdle.

Among equity funds, portfolio turnover can offer a rough proxy for trading costs.2 Turnover varies dramatically across equity funds, reflecting many different management styles. Managers who trade frequently in their attempts to add value typically incur greater turnover and higher trading costs.

Although turnover is just one way to approximate trading costs, the study indicates that funds with higher turnover are more likely to underperform their benchmarks. The reason is that excessive turnover creates higher trading costs, which can detract from returns.

SUMMARY

The results of this study suggest that investors are best served by relying on market prices. Investment methods based on a manager’s ability to outguess market prices have resulted in underperformance for the vast majority of mutual funds.

We believe the research highlights an important investment principle: The capital markets do a good job of pricing securities, which intensifies a fund’s challenge to beat its benchmark and other market participants. When fund managers charge high fees and trade frequently, they must overcome high cost barriers as they try to outperform the market.

Despite the evidence, many investors continue searching for winning mutual funds and look to past performance as the main criterion for evaluating a manager’s future potential. In their pursuit of returns, many investors surrender performance to high fees, high turnover, and other costs of owning the mutual funds.

Choosing a long-term winner involves more than seeking out funds with a successful track record, as past performance offers no guarantee of a successful investment outcome in the future. Moreover, looking at past performance is only one way to evaluate a manager.

In the end, investors should consider other aspects of a mutual fund, such as underlying market philosophy, robustness in portfolio design, and attention to total costs, all of which are important to delivering a good investment experience and, ultimately, helping investors achieve their goals.

 


Past performance is no guarantee of future results. See Data Appendix for more information.

1. Bid-ask spread is the difference between the highest price a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it.

2. Fixed income funds are excluded from the analysis because turnover is not a good proxy for fixed income trading costs.


Data Appendix

US-domiciled open-end mutual fund data is from Morningstar.

Equity fund sample includes the Morningstar historical categories: Diversified Emerging Markets, Europe Stock, Foreign Large Blend, Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Blend, Foreign Small/Mid Growth, Foreign Small/Mid Value, Global Real Estate, Japan Stock, Large Blend, Large Growth, Large Value, Mid-Cap Blend, Mid-Cap Growth, Mid-Cap Value, Miscellaneous Region, Pacific/Asia ex-Japan Stock, Real Estate, Small Blend, Small Growth, Small Value, World Large Stock, and World Small/ Mid Stock.

Fixed income fund sample includes the Morningstar historical categories: Corporate Bond, High Yield Bond, Inflation-Protected Bond, Intermediate Government, Intermediate-Term Bond, Long Government, Muni California Intermediate, Muni California Long, Muni Massachusetts, Muni Minnesota, Muni National Intermediate, Muni National Long, Muni National Short, Muni New Jersey, Muni New York Intermediate, Muni New York Long, Muni Ohio, Muni Pennsylvania, Muni Single State Intermediate, Muni Single State Long, Muni Single State Short, Short Government, Short-Term Bond, Ultrashort Bond, and World Bond.

Additional information regarding Morningstar’s historical categories is available from Dimensional upon request.

Index funds and fund-of-funds are excluded from the sample. Net assets for funds with multiple share classes or feeder funds are a sum of the individual share class total net assets. The return, expense ratio, and turnover for funds with multiple share classes are taken as the asset-weighted average of the individual share class observations. Fund share classes are aggregated at the strategy level using Morningstar FundID.

Each fund is evaluated relative to its respective primary prospectus benchmark as of the end of the evaluation period. Surviving funds are those with return observations for every month of the sample period. Winner funds are those that survived and whose cumulative net return over the period exceeded that of their respective primary prospectus benchmark. Loser funds are funds that did not survive the period or whose cumulative net return did not exceed that of their respective primary prospectus benchmark. Where the full series of primary prospectus benchmark returns is unavailable, funds are instead evaluated relative to the Morningstar category index assigned to the fund’s category at the start of the evaluation period.

Index data provided by Bloomberg Barclays, MSCI, Russell, FTSE Fixed Income LLC, and S&P Dow Jones Indices LLC. Bloomberg Barclays data provided by Bloomberg. MSCI data © MSCI 2019, all rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. FTSE fixed income indices © 2019 FTSE Fixed Income LLC. All rights reserved. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with management of an actual portfolio.

Consider the investment objectives, risks, and charges and expenses of the Dimensional funds carefully before investing. For this and other information about the Dimensional funds, please read the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund Advisors collect at (512) 306-7400 or at us.dimensional.com. Dimensional funds are distributed by DFA Securities LLC.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

Mutual fund investment values will fluctuate, and shares, when redeemed, may be worth more or less than original cost. Diversification neither assures a profit nor guarantees against a loss in a declining market. There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results.