Why We Choose Funds the Way We Do

It’s never a bad time to offer a quick refresher on why we choose funds the way we do. Over the weekend I spent some time reviewing Dimensional’s annual Mutual Fund Landscape report. Their approach for screening through millions of data points to draw of insights about investing and financial markets is unparalleled.

Our firm is a believer in Efficient Markets, meaning that security prices accurately incorporate all known information into the current price of that security. Mutual fund industry performance offers one test of the market’s efficient pricing power. If markets do not effectively incorporate information into securities prices, then opportunities may arise for professional managers to identify pricing “mistakes” and convert them into higher returns. These opportunities may be market timing strategies, long-short equity, managed futures, etc.. Many financial advisors commonly sell this to their clients and, in this scenario, we might expect to see many mutual funds outperforming benchmarks. But the evidence suggests otherwise.

Across thousands of funds covering a broad range of manager philosophies, objectives, and styles, a majority of the funds evaluated did not outperform benchmarks after costs. These findings suggest that investors can rely on market prices rather than inefficiencies. We can also recall that these strategies are often operated by some of the sharpest minds in economics, mathematics, and finance. Even with robust research budgets and armies of PhDs and CFAs, the results are uninspiring. Let us also use this data to draw conclusions about other investment structures implementing similar philosophies: hedge funds, actively managed ETFs, separately managed accounts, your neighbor that buys individual stocks, etc.

Let’s consider the details.

US Based Mutual Funds:

At the end of 2017 there were 4,760 mutual funds registered in the United States. Of those, about 46% invested in US Stocks, 34% in International Stocks, and 20% invested in Fixed Income (bonds). Collectively, these funds managed nearly $9 Trillion in shareholder wealth.

Few Funds Have Survived and Outperformed

The graphic below shows how US Equity mutual funds not only fail to outperform their benchmark indices (the teal “winners”), but it also shows how likely a fund is to shut its doors. As you can see, over last 15 years only 14% survived and beat their benchmark indices and only about half of the funds started in 2003 are still offered today. Every fund manager certainly expects to be in the Winner category when they’re starting off, and every investment advisor is going to claim to be able to identify which funds will survive and outperform –no one volunteers to be part of the underwhelming segment of the markets, but they end up there.

The Lesson Here: At the very least, we want to be sure the fund survives. We also want to pursue an approach that’s closely related to the benchmark index; this decreases the likelihood of falling deep into the category of “losers”. 

Note: A similar conclusion can be drawn in the fixed income market. We’ve omitted this for brevity.

 Are Some Funds Persistent?

The graphic below doesn’t consider a comparison to the benchmark index, but instead shows mutual funds in the top quartile (25%) of performers for two consecutive three-year periods. You can see that, on average, mutual funds in the top 25% remained in the top 25% for the next three years about 26% of the time. If we combine these probabilities, we get about a 6.5% chance of choosing a top 25% fund for 6 straight years.  This lack of persistence casts further doubt on the ability for managers to consistently gain an informational advantage on the market.

 The Lesson Here: Some fund managers may be better than others, but stock and bond returns contain a lot of noise, and impressive track records may result from good luck rather than skill. The assumption that strong past performance will continue often proves to be faulty, leaving investors disappointed.

High Costs Can Reduce Performance

One major reason why funds fail to beat their benchmarks is costs: benchmarks have none and all mutual funds incur costs. Some costs, like expense ratios, are easy to observe, while others, including trading costs, are more difficult to measure. The question isn’t about whether an investor must bear costs, it’s whether the costs are reasonable and indicative of the added value a manager is bringing to the table. The graphic below shoes the percentage of winners and losers based on funds’ expense ratios. The research tells a clear story: funds with the highest expense ratios have had the lowest rates of outperformance, especially for longer time horizons.

The Lesson Here: High fees contribute to underperformance because the higher a fund’s costs, the higher its return must be to outperform its benchmark. To increase odds of investment success, avoiding funds with unnecessarily high expense ratios is a good practice.  

Other Factors Affecting Performance

Other activities can add substantially to a mutual fund’s overall cost burden and performance outcomes. Equity trading costs, such as brokerage fees, bid-ask spreads, and price impact, can be just as large as a fund’s expense ratio.

Trading costs are difficult to observe and measure. Nonetheless, they impact a fund’s return—and the higher these costs, the higher the outperformance hurdle. Among equity funds, portfolio turnover can offer a rough proxy for trading costs. Turnover varies dramatically across equity funds, reflecting many different management styles. Managers who trade frequently in their attempts to add value typically incur greater turnover and higher trading costs. Although turnover is just one way to approximate trading costs, the study indicates that funds with higher turnover are more likely to underperform their benchmarks. The reason is that excessive turnover creates higher trading costs, which can detract from returns.

The bottom line is this: Outperforming funds are in the minority, particularly in the long term. Strong track records of performance fail to persist. High costs and excessive turnover may contribute to underperformance… The data is clear: investment methods based on a manager’s ability to outguess market prices have resulted in underperformance for the vast majority of mutual funds. Despite this empirical evidence, many investors in search of this winning formula still fall victim to compelling stories from investment salespersons. Meanwhile, investment advisors suffer from overconfidence bias and want to believe they’re the smartest of the group; I’m sure many of them truly believe they’re operating in their clients’ best interest by choosing these expensive funds. We maintain a different mindset on behalf of our clients.

We are well-equipped to focus our efforts on what we feel matters most for our clients: (1) deploying low-cost funds designed to remain comparable to a benchmark index, (2) implementing tax optimization strategies, (3) practicing disciplined diversification and rebalancing, and (4) structuring portfolios around factors of higher expected return (value, small cap, and higher profitability stocks).

Have questions about the funds we use or anything in this report? Call or email and we’ll chat about it.

 

Past performance is not an indicator of future performance. 

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