Gallery:Step 3|Stock Pickers Graveyard

The Mutual Fund Landscape—Not a Pretty Picture

Gallery:Step 3|Stock Pickers Graveyard

As we have discussed in previous articles such as this one, investors have a strong tendency to pour cash into funds that have had high returns only to be met with disappointment. If investors truly understood how stacked the deck is against them, perhaps they would avoid this sub-optimal behavior. To help investors better understand the pitfalls of manager picking, Dimensional Fund Advisors (DFA) recently issued a report, “The Mutual Fund Landscape,” which examines the challenges investors face as they navigate their way through the 6,370 funds comprising over $11 trillion in assets. As with the Standard  and Poor’s Index vs. Active Scorecard, DFA utilized the Center for Research in Security Prices (CRSP) as its source of data. This is important because CRSP data is not tainted with survivorship bias, the exclusion of funds that were closed which causes the average return of the surviving funds to be higher than it would have been otherwise. The two charts below show the significance of survivorship bias and how small a chance an equity fund investor has of picking a fund that both survives and beats its benchmark.

 

For fixed income investors, the survival rates are a little better, but the odds of picking a winning fund are even worse for the five-year and ten-year periods.

 

As with the Standard and Poor’s Persistence Scorecard, DFA found that recent outperformance of a benchmark has zero predictive value for future performance. Since track-record investing is futile, what can a would-be manager picker do to increase his odds of picking a winner? The answer is to pick a fund with a low expense ratio. While the good news is that equity funds from the lowest quadrant of expense ratios were found to be twice as likely to beat their benchmarks as funds from the highest quadrant of expense ratios over the ten years ending 12/31/2012, the bad news is that these funds still presented investors with only a one-in-five chance of picking a winner. The story is similar for fixed income where the low expense ratio funds were three times more likely to beat their benchmark but still left investors with less than a one-in-four chance of picking a winner.

At this point, it would be reasonable to ask why the mutual fund landscape is so bleak. In two words, the answer is market efficiency. These 6,370 managers are competing not just with each other but with hundreds of thousands of other traders who are all looking at the same 12,000 stocks, turning over every stone in an effort to identify mispriced securities. To both overcome the high costs of active management and beat a benchmark is a tall order to fill. Professors Eugene Fama and Ken French elegantly addressed this point in “Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates” where they evaluated 819 actively managed funds over 22 years. They found that 97% could not be expected to beat a risk-appropriate benchmark. Regarding the remaining 3%, they noted there is no clear cut way to identify them in advance. 

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.