Why Many Mutual Fund Investors Get Poor Results

The personal finance media likes to celebrate people who have beaten the market – precisely because so few manage the feat.

There is little mystery as to why this happens.  No one can buy anything unless there is a seller on the other side of the transaction. All buys are matched with sells but because buyers and sellers incur costs, their average result will be lower than the average buy and hold investor who does not incur these costs.  Some will win, some will lose.

Of course, everyone wants to be a winner.  As a result, there is often an emphasis on investing in top performing mutual funds. Unfortunately for most, they get an unsatisfactory result even if they avoid the big mistakes of trying to time the market or not being diversified enough. To use a construction metaphor, there may be a good design blueprint (e.g., a proper diversification plan) but the structure is built using inferior materials and poor techniques.

Why watch lists often don’t work well

We see this often with brokerage firms and others who utilize a “watch list” method of monitoring their portfolios. The premise is simple: you carefully monitor how the investments are doing and if any perform poorly enough, you replace them. The process sounds reasonable at first glance but it is almost destined to produce a below average result the way most implement it.

(A “watch list”) is almost destined to produce a below average result the way most implement it.

You see, someone buys a mutual fund thinking the fund has a skilled manager, pointing to a good track record as evidence of the skill. After all, it is hard to say someone is skilled if he or she has never produced a good result. Unfortunately, not enough rigor is applied to the selection process to understand exactly why the fund performed well. Understanding why a fund produced the return it did is critical to decision making.

When a fund lags some benchmark, many firms and people start to doubt whether that skill has faded or was even real to begin with and consequently put the fund on “watch.”  If performance doesn’t improve, the lagging fund is sold to buy another fund which appears to have a skilled manager based on their track record. This is where the math becomes a problem.

That new fund now needs to not just outperform, it must outperform by enough to overcome the original laggard’s deficit. As you will see, the studies show it is very likely this new fund will also lag significantly and in time find itself on watch too. It’s a vicious cycle.

In order to believe someone is skillful, what do we want to see from them? Results, of course. When you picked teams for sports at school, you picked the kids that played well in prior games.

Relying on results makes sense in the schoolyard but it does not work well when trying to find an above average mutual fund. If a particular fund manager has the ability to be on the winning side often when he or she decides to buy or sell, you would expect to see consistency in the results. However, there isn’t any that is distinguishable from what is expected purely by chance.

Past performance can be misleading

Standard & Poor’s produces a “Persistency Scorecard” which looks at whether good fund performance in one period persists into the next. The latest version verifies the pattern found in all prior runs. Of the funds that finished the year ended September 30, 2013 with a top 25% performance among the universe of funds available to U.S. investors, only 4.28% were able to deliver a top 25% result in each of the next two years. You would be expected to be more successful at selecting funds which finished in the top 25% by throwing darts at a listing of funds! Considering past performance actually reduced the odds of picking a superior fund.

Staying on top is even tougher over longer time frames. Of the funds that finished the year ended September 30, 2011 with a top 25% performance, a mere 0.28% was still in the top 25% at the end of each of the next four years. No funds investing in large or mid-sized companies pulled this off. None.

Even if the standard is just to finish in the top half, only 7.82% of above average funds were able to beat their peers each of the following four years.

It isn’t simply that almost everyone has an off year or two which causes the watch list selectors so much trouble. When should a fund on watch be sold? Surely after three years of underperformance, we can surmise something is wrong with the fund. Well, the record shows that is not necessarily so.

Masters Select funds examined the track records only of winning funds invested in the stocks of large U.S. companies. “Winning” meant beating the market over a 10-year period. They asked: how many of these winning funds lagged the market for a period of at least three years and when these winning funds lagged, how far behind the market did they fall?

The results: Almost every fund had long stretches of lagging results and many winning funds had very bad weak periods. 94% of these winning funds lagged by at least 2% per year for three years or more.  71% did so at a greater than 5% per year rate and 39% at a 10% rate. More than one in eight fell behind by over 15% per year.

A Baird study covering a different time frame got similar results and also noted that not only did the winning funds lag the market, 81% of these eventual star funds were below their peer average for stretches lasting a minimum of three years.

…81% of these eventual star funds were below their peer average for stretches lasting a minimum of three years.

The wide variance in results, even for top funds, is another form of noise from which we want to protect our clients. We rely on a sound, disciplined process backed by actual evidence, not anecdotes or the misleading nature and lack of reliability of past performance.

Better ways to manage a portfolio

With cost being so important to the likelihood of success, we are attracted to funds that have low fees but cost management goes beyond simply low fees. Every time fund management buys or sells, costs are incurred which are not included in the publicly disclosed “expense ratios.”  Some funds pay a good deal of attention to these costs, while others do not. We prefer funds that are diligent in minimizing trading costs.

Fund rankings do not consider taxes. We work hard to select funds for taxable accounts that are likely to be more tax efficient than their peers. For our clients, taxes can be the biggest expense faced by a wide margin and by being diligent about tax management, we improve the odds our clients can reach their goals.

The stock market is a device for transferring money from the impatient to the patient. – Warren Buffett

We proactively seek out new research to help identify what has the best odds of working for our clients. We want to have confidence that the drivers of good performance are likely to repeat over appropriate time frames in the future, because even the best funds backed by the best science will likely have several periods in which they look lousy. If you focus on short term performance, you can easily talk yourself into dumping a fund after a bad year, or a bad three years, and you may be bailing out on a very good fund.

We read a lot of interesting material but interesting isn’t enough. For us to be confident the inevitable periods of weak results are just temporary, funds must be structured to capture elements that matter. The structure must be built on research that shows:

• There is a sensible explanation for them;
• They are persistent through time;
• They are pervasive across markets;
• They are robust to alternative specification;
• They can be cost effectively captured in broadly diversified portfolios.

All funds say they have what it takes to produce a superior result, but that isn’t true because by definition it can’t be true. We can’t rely on a fund management’s subjective review of themselves or a cursory review of past performance when selecting funds or other investments.

When building your financial house, we want a great design built with the best materials and techniques available. We delve deep into the reasons a fund may have done well to ascertain if those reasons are likely to produce good results in the future. This is yet another way we identify harmful noise in the data and sales pitches and provide “A sanctuary from the noise ®” for our clients.