Thursday, August 5, 2010

Can your managed mutual funds beat my index funds?
by David Gilfix

I know enough about finance to know that I don’t know enough about finance.

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.
During most 10 periods, the index funds outperformed managed funds by an even greater margin. For example, Lee McGowan, writing for Guide, says that according to Vanguard, during the 10-year period ending in 2007:
  • 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?


Scam Buster, AKA David Merfeld said...

David, interesting column.

How do so many of these families of funds manage to report such good past performance? They game the system, that's how. Consider an infamous old scam. A con artist selects thousands of names at random, from the phone book. He emails (OK, when the scam was old, he would write, but you get the idea) all of them, predicting the outcome of a sporting event the following weekend. To half of them, he writes that Team A will win; to the other half, he writes that Team B will win. Sure enough, one team wins. He discards the names of those to whom he gave the bad prediction, and repeats the process, with the half to whom he gave a good prediction. After many rounds, he now has a group (albeit a much diminished group) to whom he has given the right prediction many times in a row. Now he writes to these people, who think he must have a weekly lunch date with God, telling them that he will only give a prediction for the next week's game if they pay him. He waits for the checks to roll in.

What does this scam have to do with the mutual fund scam? It tells us that you can be sure of a winning bet by betting on both outcomes, and discarding the wrong outcomes. And, of course, that is exactly what the mutual fund industry does, by euthanizing losing funds, and retaining winning funds. When you look at the performance of a family of funds, you see a selected group, unburdened by their bad guesses (oh, sorry, I meant bad "expert" predictions).

Jim said...

Another article to check out, "Index Funds Win Again," NY Times (google it). Like you said, managed funds can't time the market and their expenses are much higher than index funds. Thanks for the research.

Ralph said...


As usual, this is a very astute observation of something that appears very complicated on the surface but which you are able to boil down to common sense. Good article!

Peter said...

Nice article!

Another factor in favor of Index Funds is the much lower level of management fees. So even if the all the funds are performing the same there is a substantial difference in outcomes over the long term.

Michael said...

I realize this is an old post but I just saw your blog, David.

Some comments:
1) I think you realized during the discussion that you asked the wrong question. Rather than can they beat (of course some can and will) you should ask what is the likelihood they will beat? Yes they can but it is not likely enough to justify buying them.
2) The conclusion that good past performance is a predictor of bad future performance is probably just regression to the mean. Same with Hubert's experiment. In the long run we would expect to see returns settle back to a long run average so good will eventually follow bad and bad will eventually follow good.
3) Having said that, there are managers who can consistently beat the market. Warren Buffett comes to mind as someone who has done very well picking stocks (and companies), but of course Warren would tell you to put your money in index funds.