By Gary Brooks, CFP®
Mutual fund investing presents one of the great conundrums of personal finance. It seems logical that a professional manager, armed with piles of data and research analysts to decipher it, should be able to weed bad investments from good and produce returns that are better than the collective market return.
While many mutual fund managers occasionally post periods of exceptional returns, research is unveiling that performance outliers are more likely due to luck than any repeatable skill. Persistent mutual fund outperformance of a comparative index is the Sasquatch of investing. It doesn’t exist.
That doesn’t mean it’s impossible for a professional money manager to add value. But it’s difficult to post market-beating returns every year or quarter. This is particularly true for U.S. stock mutual funds and to a lesser extent for international stock funds and bond funds. Many fund managers have produced noteworthy long-term records where the totality of performance has been better than the market, but from time-to-time, their investment approach is out of favor and lags the passive index (e.g., the S&P 500).
A good example of this is Oakmark International Fund (OAKIX). Over periods longer than three years, the fund is among the top 5% of its peers. Over 15 years, it has nearly doubled the return of its benchmark. But over the past year, its peer-relative performance has reversed. It has been among the bottom 5% of its category. Morningstar’s fund analysts give Oakmark International five stars and a gold rating, but the conundrum is clear. Strong performance over time brought more money into the fund making it more difficult to produce excess returns (more on this later). Decisions about individual stock holdings and determining levels of exposure to Europe vs. Japan apparently held back recent returns.
U.S. stock mutual funds offer many more examples of intermittent outperformance interrupted by periods of lagging performance.
INVESTORS UNDERPERFORM FUNDS, FUNDS UNDERPERFORM THE MARKET
It would seem that evidence of solid longer-term returns would be enough to create patience from investors. But few investors have the staying power required to experience the long-term outperformance amid short-term fluctuations. Investors pour money into funds when they are hot (after good returns have already been earned to drawn their attention) and redeem when they are not, therefore, few investors actually receive the same stated performance as the funds they invest in.
Research from Morningstar as of the end of 2013 demonstrated that over the preceding 10 years the average U.S. mutual fund investor underperformed the average U.S. mutual fund by 2.49% per year. The typical investor earned 4.8% annualized compared to 7.3% for the typical actively managed mutual fund across all asset categories.
Even if an investor received the returns of the average mutual fund, they may still trail the return available from simply holding a passive, market-tracking index fund with very low costs. The latest measures the S&P Dow Jones Indices Versus Active (SPIVA) Scorecard show that over the three years through June 30, 85.9% of all U.S. stock fund managers failed to outperform their passive benchmarks. Over five years, 73.6% lagged. International stock managers and bond managers beat their benchmarks more often but over many periods it is still not a majority that do.
Perhaps you’re thinking that even though the majority of the industry trails its benchmark that you can still identify those mutual fund managers that have and may continue to outperform. The challenge is that it’s not always the same mutual funds that outperform or underperform. Funds move across borders regularly as their investment approach moves in and out of favor with market conditions.
Another common argument for actively managed mutual funds is that they will demonstrate more value during declining markets. If you invest in a stock index fund, you expect 100% of the return in a climbing market and 100% of the decline. Theoretically, a professional manager should be able to steer around the largest potholes in the investment landscape and win by “losing less” so to speak. While it is more likely for an active mutual fund manager to outperform an index during declining markets, a majority of them still do not do so according to the SPIVA Scorecard. Most alarming in the 2008 bear market was the performance of U.S. large-cap growth managers. Growth stock managers are less concerned with fundamental factors of value and more interested in future earnings growth. They naturally have less protective buffer for down markets. In 2008, 90% of growth managers trailed passive benchmarks according to the SPIVA Scorecard. Only 22% of U.S. large-cap value managers trailed their index in 2008. Value managers more often have stringent discipline for buying companies only when there is a margin of safety. They buy with a “heads I win, tails, I don’t lose too much” mentality.
Even when investors chose funds wisely and remain committed to them, the pursuit of persistent performance is regularly interrupted by a series of common occurrences.
REASONS FUNDS EVENTUALLY LAG
Often, strong performance is derived from a small handful of big winners in the past. The fund manager makes well-timed entry into – and possibly exit from – holdings that might not even be in the portfolio any more. Profits are captured, good performance recorded and attention is gained. New money flows into the fund and a whole new challenge arises; it’s a lot easier to manage a small sum of money than a large one.
When new money flows into a fund, the manager has three options; add to existing holdings in the fund (possibly buying into them at a higher price than previously), step down their ranked list of investments to choose a new one that they have less conviction for than their previous investments, or sit on cash and wait for a more appealing time to buy.
Amid these three options, luck often masquerades as skill. Professional investors today have more information available than ever before. As computing power and information improve and nearly everyone makes decisions based on the same information, it becomes harder to separate many equally skilled or efficient money managers. Luck, therefore, becomes more relevant in separating the winners from the losers.
Standout performance is often simply the result of taking more risk and having it pay off. A manager may have concentrated in a narrow idea and timed the investment well. Or a speculative hunch may fly high. Whatever the origin, a fund manager may achieve a good outcome from a flawed or risky process. It may actually be preferable to have a momentarily mediocre outcome from a good process if you trust that the process will have a higher probability of working over time, beyond the intermittent luck.
If a fund manager is skillful enough to identify a specific strategy that generates market-beating returns, it’s not likely to last long. Where profits are made, others follow. There may be delayed reactions and catch-up time required, but there are no secrets. When more investors implement similar strategies, the impact will be diluted for all.
OTHER DRAWBACKS OF ACTIVE MUTUAL FUNDS
- Active mutual funds come with ongoing management fees charged by the fund manager. These fees are usually labeled the fund’s expense ratio. These fees are used to pay the fund manager and team of analysts, traders, etc. for the operation of the fund. Usually, as funds manage more money, the management fee declines as a percentage of the investment. If the fund has poor returns, the management fee does not usually decline.
- Some portions of the market are less efficient to research and invest in so it’s justifiable for funds in these categories to cost more, but there are almost always lower-cost options such as index mutual funds or exchange-traded funds.
- Aside from fees and intermittently good performance, the most irritating characteristic of mutual funds is their lack of transparency. Mutual funds are required to disclose their underlying investments only quarterly. Evaluating performance and current positioning can be difficult when the information available is three months old.
- Investing in a pool with others means that your returns are partly dictated by the behavior of the other investors in the pool. If cash flow exits a fund quickly, a manager may be forced to sell investments in order to meet redemptions. If good performance brings in new money, we covered earlier the three options the fund manager has. Few of them are able to sit on cash until an attractive opportunity develops.
- Many fund families produce several different share classes of each mutual fund. Each share class could have different management fees. Some have different investment minimums. Others have commissions in addition to fees. Finally others are available in only certain types of accounts. Determining which share class is best for you can be confusing.
- Active mutual funds are managed by people. Fund managers and analysts change. They retire. They switch firms. The recent move of Bill Gross from PIMCO to Janus is the most high-profile fund manager change in quite a while. Less newsworthy but still important manager changes happen more frequently. If a manager leaves a fund – or even an important analyst departs – it’s difficult to determine how the change will impact future decision making and performance of the fund.
- There are thousands of funds to choose from. There is no way you will choose the optimal fund in each category to build your globally balanced investment portfolio – and have those funds remain the optimal choices over time.
WHAT YOU CAN DO
- Start by having a financial plan which outlines your financial situation, goals and risk tolerance.
- Reduce your emphasis on market-beating performance and increase your understanding of the returns needed to make your financial plan work, taking no more risk than necessary to reach your goals.
- The level of risk in your investment portfolio is mostly attributed to the weight of stocks vs. bonds, more so than the selection of any particular individual investment. You can control the amount of risk you take by managing your mix of stocks vs. bonds, U.S. vs. international, etc. This is more critical than trying to pick just the right funds.
- Don’t base investment decisions solely on performance. When evaluating mutual funds, try to understand the people and process involved and what attributes have created short and long-term outcomes. Some fund managers are comfortable sacrificing up-market returns in exchange for a lower level of risk and better down-market protection. Especially learn if the same manager who generated the performance still leads the fund.
- Use actively managed mutual funds for the portions of your portfolio where they are more likely to generate better returns than passive funds. These tend to be emerging markets stocks, global bonds, and alternative investments.
- You can reduce the costs of your investments thereby increasing the amount of return you get to keep by using more low-cost mutual funds and exchange-traded funds.
- If your employer retirement plan offers only actively managed mutual funds – especially if they are high-cost funds – request that index funds be added to the plan.
- Invest in funds where the managers have committed a meaningful amount of their own money to the strategy. It’s comforting to know that the people making the buy and sell decisions have their money right next to yours.
As of this writing, 60% of the assets we manage for clients are in mutual funds. Much of that total is in mutual funds that have costs below their peers and attractive long-term performance records. This includes funds from Vanguard, Primecap, Dodge & Cox, etc. Exchange-traded fund choices continue to improve, providing asset class diversification, rules-based investment strategies and transparency all at significantly less cost than most mutual funds. We expect to continue selectively shifting more assets into ETF products.
~ Brooks, Hughes & Jones Wealth Advisors – Tacoma, WA