wisdom of crowds

Are Investors Irrational When It Comes to American Funds?

wisdom of crowds

A recent edition of the Rekenthaler Report from Morningstar would have us believe that American Funds have suffered investor withdrawals due to a guilt-by-association with active management which has increasingly come under fire from both academia and from key players in the investment industry such as Standard and Poor’s. Rekenthaler cited the twelve largest all-equity American funds, and he found that eight of them delivered positive alpha in 2013. We checked the returns of those funds against their Morningstar analyst-assigned benchmark, and we concluded the same. In fact, we found the average alpha of those twelve funds to be 3.0%, yet American Funds suffered net redemptions of about $22 billion in 2013, the worst of all the major mutual fund families. How can this be? Rekenthaler explains it as follows:

“American Funds must shoulder partial blame for its sales problems. The company permitted expectations to climb dangerously high following its successful 2000-02 period, leading to disappointment and recriminations when it failed to perform a similar miracle during the 2008 market crash. However, the company has also suffered for the sins of others. Most active managers have not beaten the indexes on a net basis, either on total returns alone or risk-adjusted. This has led to the popular belief that that such a feat cannot be produced. It can be.”

Just to clarify, we at Index Fund Advisors have never said that it is impossible for an active manager to deliver alpha—just that it is difficult (and very rare) for active managers to both overcome their costs and beat their benchmark to a degree consistent enough that we would conclude skill is the explanation. Furthermore, the potential harm incurred from a manager falling short of his benchmark usually exceeds the potential benefit of exceeding it, so most investors are best served by a portfolio index funds that is matched to their Risk Capacity.

To bolster his argument that 2013 was not simply a fluke, Rekenthaler analyzed 10-year Sharpe ratios (a measure of excess return received per unit of risk taken), and he found that eleven of the twelve funds beat their category benchmarks. However, we found that only eight of the twelve beat their benchmark by a wide enough margin to not be technically considered a tie (a difference in excess of 0.03). A few months ago, we completed an analysis of the historical returns of 37 American Funds (both equity and fixed income) in which we went as far back as either the fund or its Morningstar analyst-assigned benchmark. We found that 35% (or 13 funds) had positive average alpha over the period, and only 5.4% (or 2 funds) had a consistently high enough alpha, and a low enough standard deviation of alpha, and a large enough sample size of data that we could be at least 95% confident the alpha was due to skill rather than luck.  

This important distiction between luck and skill is what Mr. Rekenthaler left out of his analysis. The calculator below shows the formula and an input form for you to calculate the number of years needed for statisical significance, otherwise know as a t-stat of 2. We first determine the excess return over a benchmark (the alpha) then determine the regularity of the excess returns by calculating the standard deviation of the alpha. Based on these two numbers, we can then calculate how many years we need (sample size) to support the manager's claim of skill. If we do not have a long enough track record, we write the alpha off as luck, and luck is not expected to persist. Even at a t-stat of 2, there is a 1 in 20 chance, or 5% chance we have errorred and attributed skill to luck. That is about the result we came up with when only 5.4% of the American funds we analyzed appeared to be skillful. We published an article titled False Discoveries of the Elusive Alpha which provides further information on this topic. 

We urge you to let go of your desire of trying to identify an active manager who has more information and wisdom than the approximately 10 million global traders that embed their individual profit-motivated wisdom in about 40 million global trades of about 10 billion shares every trading day. (Source: IFA estimates)

Going back to the question of why American Funds has been hit with large redemptions for the past couple of years, the most likely explanation that we can think of is that their investors are shifting to the strategy that affords them the highest probability of meeting their long-term financial goals—indexing. If you would like to learn more about the benefits of indexing, please give us a call at 888-643-3133.