So last spring, I attended a financial fair for teachers to learn more. I spoke to three financial experts representing different financial firms, and I asked each of them the same question: can your managed mutual funds beat my index funds?
Did I mention that I don’t trust experts?
So what was I supposed to conclude when all three experts agreed that (of course!) their managed funds could beat index funds? I concluded that the situation needed the perspective of a non-expert like me to analyze the issue with whatever grey matter was left between my ears after years of trying to understand the stock market.
Here’s what the experts said, followed by my “grey matter” analysis:
1. Financial experts: Managed funds can beat index funds because the experts thoroughly research each company stock they buy or sell and then sell off stocks of companies that won't perform well in the future.
The ol’ grey matter: Yes, index funds have to keep all companies that fit the requisite profile of their particular index; and yes, managed funds can sell off poorly performing stock or stocks that appear to be in trouble, which seems like a slam-dunk advantage for the managed mutual fund companies.
Except for one problem: In order to sell stock you need a buyer. But who buys these shares of a company from an expert mutual fund manager (supported in the selling decision by expert financial analysts)? Since mutual funds buy and sell huge lots of stock, usually the buyers of these blocks are other big investment institution (including other mutual funds), advised by other expert financial analysts! In other words, there have to be experts who believe a company is a good buy, at a given price, at the same time that there are experts who believe the company is a good sell, at, by golly, the same price. Yet, only one of them can be correct, which means that half of them will be wrong. So why should I trust one expert mutual fund manager over any other expert investor?
Which is exactly what I asked the three financial experts, and they all answered in the same way. Ready?
2. Financial experts: Only the best-managed funds can beat the indexes. To find them, it is critical to examine the track record of the fund and the fund manager. Additionally, it is wise to consider the fund recommendations of top independent financial journals. (All three experts at the fair claimed to use funds that had beaten the indexes and were recommended in financial newsletters).
The ol’ grey matter: OK, this seems to make sense. But wait! How reliable is either past performance or recommendations from journals as a predictor of mutual fund success?
Here, I must confess, these financial experts were completely correct. Past performance is indeed a good indicator of future performance: good past performance is a strong indicator of bad future performance! Consider:
- A study of 144 equity portfolios from 1975 to 1989, by Barksdale and Green, revealed that the funds which were in the top quintile over a 5-year period were the least likely to finish in the top fifty percent over the next 5 year period, as reported by Larimore, Lindnauer, and Beboeuf in the book, Bogleheads.
- Other information provide by Bogleheads include this: Since the 1960s, the average return of the top 20 managed mutual funds in each decade was below the market indexes for the next decade.
- And this: Not a single one of the top 50 performing mutual funds in 2000 were among the top 50 performing mutual funds in 1999 or 1998.
OK, so much for relying on past performance, but what about the recommendations from professionals who study mutual funds full-time?
John Graham and Cahill Harvey, professors at the University of Utah and Duke University, respectively, studied 237 newsletters and concluded that there was no evidence they could time the market. Mark Hubert, founder of Hulbert Financial Digest, which tracks the advice of more than 160 financial newsletters, ran an interesting experiment: What would happen if he constructed a hypothetical mutual fund model for each year, based on the top performing mutual fund portfolio of all financial newsletters for the previous year? Answer: after 18 years, the return on this portfolio would be, on average, “30 percentage points per year below what you could have achieved simply by buying and holding the stock market itself (as judged by the Dow Jones Wilshire 5000 index),” as reported in The Wall Street Journal.
So if the full-time expert analysts writing the expensive financial newsletters can’t pick a portfolio of managed mutual funds that can beat the market, why would I trust financial advisors/brokers to do any better?
A different financial advisor answered simply that if I am comfortable with the returns I am getting in index funds, then I should stick with them – a comment that made total sense, until I realized it was a great sales tactic. Of course I’m not “comfortable” with recent returns! Is anyone? The question is whether I would be any more comfortable with managed funds. Probably not.
The hard truth, as reported by Mark Buek on research by Bankrate, is that index funds have way outperformed managed funds over most “rolling” 5-year periods. For example, during the 5-year period ending in 2008:
- The S&P 500 outperformed 72 percent of its active large-cap competitors;
- The S&P 400 MidCap index beat 79 percent of active mid-cap funds; and
- The S&P SmallCap 600 beat nearly 86 percent of active small-cap funds.
- 84% of managed U.S. large blend funds underperformed their index; and
- 95% of managed bond funds underperformed their indexes.
Let’s get back to the financial fair I attended last spring. The way I see it, when you choose managed mutual funds (rather than index funds), you are choosing to trust a chain of experts: The expert advisor who helps you choose the funds, the expert analysts in the financial newsletters who inform the advisor, and the expert mutual fund manager who will attempt to outperform the indexes.
Did I mention that I don’t trust experts?