Active Mutual Fund Managers Not Getting Any Better

Below is a copy of a post from a blogger I follow - The White Coat Investor: A doctor who tries to help his peers through the noise of all things financial.

This is a great summary of recent performance of actively managed mutual funds relative to their respective index:

Active Mutual Fund Managers Not Getting Any Better

Posted on January 28, 2013 by White Coat Investor

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Every year Standard and Poors publishes a “scorecard” comparing active mutual fund managers to the indexes.  Every year it’s pretty much the same story- active fund managers can’t persistently beat a passive investment.  This year’s version recently came out.  Here are the highlights:

1) From September 2009 to September 2012, 23.6% of large-cap funds, 15.5% of mid-cap funds, and 29.4% of small-cap funds remained in the top half with regards to fund performance (AKA beat a low-cost index fund.)  Random chance would lead to 25% of remaining in the top half for all 3 years.

2) From September 2007 to September 2012, 5.2% of large-cap funds, 3.2% of mid-cap funds, and 5.1% of small-cap funds remained in the top half for all 5 years.  Random chance would lead one to expect at least 6.25% would remain in that category.

In essence there is no persistence of performance.  You CANNOT choose an actively managed mutual fund based on past performance and expect that to persist in any way, shape, or form.  Actually, that’s not entirely true.  There is some persistence of performance….among the bottom quartile funds.  They’re much more likely to be merged or liquidated than better performing funds.

As one part of the study they took mutual funds that performed in the bottom half over a 5 year period and took a look at how they performed over the next 5 years.  For all US Domestic funds, those in the bottom half over the first 5 years had a 36.8% chance of being in the top half over the next 5 years, a 34.5% chance of being in the bottom half, and a 28.7% of disappearing completely. Now, I think it’s safe to say that those that disappeared weren’t doing well, so in reality 63.2% of bottom half funds stayed in the bottom half.

Moral of the story?  Good funds go bad and bad funds stay bad.  If the chances of you choosing a 5 year winner are only 1 out of 20, and you have to do this for 5 or 10 different asset classes, the odds of you designing an actively managed portfolio that will outperform a passively managed portfolio seem astronomically small.  Save yourself the trouble and buy low-cost index funds.

A Concise Explanation of Efficient Markets and The Difficulty of Truly Beating The Market

Nate Silver uses the efficient market hypothesis (EMH) to demonstrate how our brains will use simplified models.

The simplified EMH - the simple statement in #1 below,  is often attacked by those who say that the EMH is invalid. But, by the time you read to #7 - which is a concise definition of the EMH, it becomes much harder to argue against the EMH.

The next time someone claims to outperform the market you should ask: Do they outperform relative to risk and transaction costs?

Nate Silver:

"Consider the following seven statements, which are related to the idea of the efficient-market hypothesis and whether an individual investor can beat the stock market. Each statement is an approximation, but each builds on the last one to become slightly more accurate.

1. No investor can beat the stock market.
2. No investor can beat the stock market over the long run.
3. No investor can beat the stock market over the long run relative to his level of risk.
4. No investor can beat the stock market over the long run relative to his level of risk and accounting for  his transaction costs.
5. No investor can beat the stock market over the long run relative to his level of risk and accounting for his transaction costs, unless he has inside information.
6. Few investors beat the stock market over the long run relative to their level of risk and accounting for their transaction costs, unless they have inside information.
7. It is hard to tell how many investors beat the stock market over the long run, because the data is very noisy, but we know that most cannot relative to their level of risk, since trading produces no net excess return but entails transaction costs, so unless you have inside information, you are probably better off investing in an index fund.

The first approximation—the unqualified statement that no investor can beat the stock market—seems to be extremely powerful. By the time we get to the last one, which is full of expressions of uncertainty, we have nothing that would fit on a bumper sticker But it is also a more complete description of the objective world."

Nate Silver (2012-09-27T00:00:00+00:00). The Signal and the Noise: Why Most Predictions Fail-But Some Don't (Kindle Locations 7462-7475). Penguin Press HC, The. Kindle Edition.