Chart on Mutual Funds vs Indexes

A Graphical View of the Mutual Fund Landscape

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Chart on Mutual Funds vs Indexes

Since IFA began operations in 1999, we have published articles detailing how incredibly stacked the odds are against successfully picking a manager who will beat his benchmark (i.e., deliver alpha). See here and here for recent examples. However, as we like to say at IFA, a good chart is worth a thousand words, so we prepared the chart below which shows the plotting of over 200 actively managed funds on a 20-year reward vs. risk chart. Click on the asset class links in the legend to isolate that asset class and the appropriate IFA Index. Roll your mouse over any button to see the name of the fund, annualized return, standard deviation and the t-statistic of alpha (you want a t-stat greater than 2).

The first thing to bear in mind is that we are looking only at funds that have survived for 20 years. In addressing the issue of survivorship, Vanguard1 found that over the 15 years ending 12/31/2012, only 55% of funds that began the period survived for the entire period. This implies a 4% attrition rate, which over 20 years would lead to a 44% survival rate. Thus, we are really looking at the survivors of about 500 funds from the beginning of the period. It is hard to be a long term investor if your fund goes out of business.

So just how did these funds perform relative to the risk they imposed on their shareholders? Comparing them to the line formed by the ten IFA Index Portfolios, the word that comes to mind is “dismal”. We see many more that lie below the line compared to the number that lie above the line. Of those that were distinctly above the line, we only found one whose alpha was significant, or was reliable to the degree that we would rule out luck as the explanation based on a 95% level of confidence (still leaving room for a 1 in 20 chance of error). The benchmarking methodology used in this analysis was based on Nobel Laureate Eugene Fama and Kenneth French's Three-Factor regression on monthly returns.  When we performed a second type of test on this fund (Mairs & Power Growth) comparing its annual returns to its Morningstar analyst-assigned benchmark, it no longer showed significant alpha.

While there was one other fund (Franklin Flex Cap Growth) that also had significant alpha, that fund essentially lies on the extension of the line formed by the ten IFA Index Portfolios, and its level of risk (volatility) would have been too high for most shareholders to endure. Please bear in mind that you would have had to select one of those funds that lie above the line twenty years ago and held it the entire period to get a higher return.  Finally, those funds may not show a winning performance over the next 20 years, especially considering the fact that the same manager is not likely to be managing the fund over the next 20 years. 

While diversification both within and among asset classes is essential to capturing the returns that are offered by financial markets, diversification among active managers is essentially a guarantee of subpar results. This becomes quite apparent when one visualizes selecting say five funds at random from the 200 funds shown above (which again, are the survivors); the average return of those five would almost certainly fall well below the line of IFA portfolios.

In closing, we can’t help but mention the one outlier fund with the lowest return, the Midas Magic Fund. Clearly, if there was a fund that should have gone out of business a long time ago, this would be it. Carrying a ridiculously high expense ratio of 3.31%2, the only magic to this fund is the disappearance of the wealth of its shareholders. The Midas part of the name is definitely appropriate because it perfectly captures the greed of the fund managers. The t-statistic for this fund is below -2 which means that we are more than 95% certain that the manager has negative skill.

If you are currently on the manager picking treadmill and would like to learn about a better way to invest via index funds, please call us at 888-643-3133.

1Wimmer, Brian R., Sandeep S. Chhabra, and Daniel W. Wallick, 2013. The Bumpy Road to Outperformance. Valley Forge, PA: The Vanguard Group. accessed on 6/11/2014.