no active funds

Using Randomness to Create Fiction: Fidelity Fights Back Against Passive Investing!

no active funds

Fidelity Investments is one of the biggest and most well-known money management firms in the world. Peter Lynch, one of the most legendary money managers, is an alum of Fidelity, guiding their Magellan Fund (FMAGX) to historical heights from 1977 to 1990. Boasting a total of 280 different strategies spanning across all asset classes, their investment footprint is very apparent. They are also very proud proponents of active investing, with almost 85% of their fund lineup based on active strategies.

In the midst of the growing evidence that the majority of active mutual funds underperform their respective benchmarks overtime, Fidelity has published a series of studies showing the superiority in performance for a subset of active funds.1 According to their own research, there are two primary “filters” or screens that investors can use to zero in on potential long-term investment strategies that are likely to outperform: size of fund family and cost. In other words, those fund management companies that are large in size (in terms of assets under management) and are the most cost-effective (in terms of expense ratio) have historically outperformed simple index funds.

The chart below displays the average yearly excess returns for US large-cap equity funds. From 1992-2015, the entire group, as a whole, underperformed their benchmarks by an average of 0.71% per year. Once we filter the group based on expense ratios in the lowest quartile and top five fund families based on AUM, then the group outpaced their index counterparts by an average of 0.18% per year. In 2015 alone, this group outpaced the passive alternative by 0.70% on average.

Fund data from Morningstar, including closed and merged funds. Excess returns are returns relative to the primary prospectus benchmark of each fund, net of fees. Average excess returns: the average of all monthly one-year rolling excess returns for all funds in the set under analysis, using overlapping one-year periods and data from Jan. 1, 1992, to Dec. 31, 2015. Fee filter selects only funds in the lowest quartile of expense ratio. Resources filter selects by assets under management in U.S. large-cap equity funds; for active, the filter selects from the top five fund families by AUM; for passive, selects for top 10% of funds by AUM, for comparable selectivity. Filtered sets are rebalanced monthly, using reported AUM and expense ratio; forward one-year returns are used for each filtered set. Basis point: 1/100th of a percentage point. Past performance is no guarantee of future results. This chart does not represent actual or future performance of any individual investment option. See endnotes for important information. Filters were selected by Fidelity; other filters or filter parameters may produce different results. Source: Morningstar, Fidelity Investments, as of Feb. 9, 2016.

Source: "Some Active Funds Rise Above A Tough Year", Fidelity Viewpoints. Forbes., March 24, 2016

 

IFA has written about Fidelity’s research in this particular topic before in Fidelity Has Found the Holy Grail: Oh Wait, False Alarm where we discussed some of the major flaws in Fidelity’s so-called “research." But let’s first just point out the obvious.

This is a great example of research with conclusions that are extremely self-serving for those who conducted it. Fidelity just happens to be one of the largest fund managers based on AUM and low and behold, has a lower expense ratio than their colleagues, on average.

What is also missing from this discussion is the reliability around their figures. How confident can we be that the 0.18% per year “alpha” will persist in the future? We have written extensively about the many statistical pitfalls that most fund managers fall into once we dissect their performance thoroughly. In fact, we released a two part series last year dispelling Fidelity’s own belief that their strategies can deliver reliable outperformance versus a simple buy and hold index fund. Based on their strategies with at least 20 years of performance data, not a single strategy has provided a reliable “alpha” (once sector funds are removed) and the vast majority underperformed their benchmark. The chart below plots the individual strategies’ alpha and standard deviation of their alpha. Not applying this level of scrutiny to performance data is, in our opinion, leads to a very different conclusion about future investment success. Results have been similar for American Funds, Thrivent, USAA, JP Morgan, and MFS Investment Management.

Third, Fidelity’s sample, based on Morningstar, in their research also falls victim to survivorship bias, which can inflate performance figures astronomically over long time horizons. When comparing the performance of funds over long time periods it is essential that the sample accounts for the funds that failed or were merged with other funds. Their performance still needs to be accounted for even though they may no longer be in the Morningstar database. 

Lastly, part of Fidelity’s story defies basic logic. While we readily agree that lower expense ratios will likely provide better performance, for fund families that are larger in terms of assets it doesn’t make all that much sense. The more assets these fund complexes gain, the more money they have to dedicate to whatever active strategy they are attempting to capture. This means that, on average, more and more money on the opposite side of the trade has to be wrong in order for the “alpha” to manifest itself. The likelihood of being able to consistently outsmart more and more participants in the market becomes extremely difficult. This is often why many hedge fund managers prefer a ceiling on the assets they manage in order to stay “nimble.” The other point to consider is that as these fund complexes become extremely large (multiple trillions of dollars), the more they become the actual market. They move prices the most when they trade. We have seen this phenomenon when it comes to Fidelity’s strategies as well as American Funds in which their net performance is simply the market return minus their fees.

By trying to make an argument for active management that is completely self-serving, based on no scrutiny in terms of statistical significance, and defies basic logic, you are placing yourself firmly into the category of fiction. This type of research plays on investors’ emotions and knee-jerk reactions and is not firmly rooted in any sort of peer reviewed academic research. We want to be able to provide enough insight so that investors can make informed decisions and not be fooled by randomness. 



[1] Healy, Beth. “Fidelity Strikes Back at the View that Passive Index Funds Beat Active Managers.” The Boston Globe. March 23, 2016. https://www.bostonglobe.com/business/2016/03/23/fidelity-strikes-back-view-that-passive-index-funds-best-active-managers/LymmN1HtKaMA1InLFVmUzO/story.html