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Do Active Funds Outperform the Market? (Part II)


We’ve talked about the different types of mutual funds. Historical performance shows that it doesn’t matter what type of mutual fund an investor holds, one cannot consistently outperform the market. Now we’ll look at the best ranked mutual funds and managers, regardless of the fund type.

Morningstar

So what about Morningstar? One of the most common ways for individual investors to select mutual funds is by their Morningstar rating. Christopher B. Philips and Francis M Kinniry Jr. examined whether a mutual fund with a high rating would outperform a mutual fund with a low rating. The published their findings in the paper “Mutual Fund Ratings and Future Performance.” They stated:

We also find that a given rating offers little information about expected future relative performance; in fact, our analysis reveals that higher-rated funds are no more likely to outperform a given benchmark than lower-rated funds, and that the value of indexing stems in large part from low operating costs and the zero-sum game.[i]

Within their study they found only 39% of five star rated funds outperformed their benchmark in the following three years. On the other hand, 46% of one star rated funds did. The bottom line is that Morningstar’s ratings system does a great job of “predicting the past.” It continually favors yesterday’s winners.[ii]

Skill versus Luck

Skill and luck are not directly observable. Thus, we are left with observing performance. Bradford Cornell, a professor of financial economics at the California Institute of Technology contributed to a study named “Luck, Skill and Investment Performance”. He analyzed the performance of 1,034 funds and came to the conclusion that 92% of the cross sectional variation in fund performance is due to random noise.[iii]

Professors Eugene Fama and Kenneth French also studied this issue and came up with the same findings. They did concede that when looking at gross returns (returns before expenses) more variation could be attributed to skill not luck. However, gross returns are irrelevant to investors unless they find a manager who will work for free! Suffice to say, every investor should really pay heed whenever Nobel Laureates have something to say on the topic! Good luck finding a fund manager with the compensation ambitions for his own wallet akin to Mother Theresa!

Final Thoughts and Conclusion

When looking at mutual funds, the evidence highly favors the efficient market hypothesis. There are no examples of actively managed mutual funds that exhibit consistent outperformance due to the manager’s skill. Even if fund managers were to find inefficiencies within the market, the expenses of exploiting these inefficiencies (and the resulting fees charged to investors) outweigh the potential meager excess return by miles! Don't let anybody trick you into believing otherwise!

Sources:

[i] Philips, Christopher B. and Francis M. Kinniry. "Mutual Fund Ratings and Future Performance." Vanguard Research (2010).

[ii] Swedroe, Larry E. The Quest or Alpha. Hoboken: John Wiley & Sons Inc., 2011

[iii] Cornell, Bradford. "Luck, Skill and Investment Performance." Journal of Portfolio Management (2009).

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