In the world of investing, people are always in search of managers who will deliver alpha, or returns above the appropriate risk-adjusted benchmark. This search revolves around two competing theories. Are markets efficient or inefficient? If markets are inefficient, skilled investors can find pricing errors and consistently beat the market. Through stock selection and market timing, they perform the art of active trading to beat the market. The competing theory is based on the body of work known as Modern Portfolio Theory. This assumes that the markets are highly efficient and efforts to outperform are unlikely to prove productive, especially after trading expenses.
In order to test which theory is correct, we’ll look at the history of many different types of funds and investments. In this article we’ll take a look at actively managed mutual funds. In order to show that markets are inefficient, we need to see evidence of persistent outperformance beyond the randomly expected.[i]
Survivorship Bias
One way for mutual funds companies to attract potential investors is through a presentation of their past performance. If they show that their managers have shown great historical performance, investors may be inclined to believe that these results will continue into the future. Investors must be wary though. Many mutual fund companies have a tendency to drop poor performing funds, generally because of poor results or low asset accumulation. This results in an overestimation of the past returns of mutual funds.[ii] The following table shows just how much survivorship bias play a role in performance results.
Figure 1 clearly shows that survivorship bias increases as length of time increases. The rate of increase seems to flatten out at sufficiently long sample lengths. For time periods of 15 years or longer, 1% is probably a good approximation of the bias in mean annual performance estimates.[iii] As we review the performance of mutual funds, the survivorship bias should be kept in mind as it inflates the stated returns.
Equity Funds
There are many studies on the performance of actively managed equity mutual funds.[iv] The evidence from these studies are consistent with one another and overwhelming. In a study done by Mark Carhart he found that the average actively managed mutual fund underperformed its appropriate passive benchmark by about 1.8% a year. He stated in his works:
Persistence in mutual fund performance does not reflect superior stock-picking skill. Rather common factors in stock returns and persistent differences in mutual fund expenses and transaction costs explain almost all the predictability in mutual fund returns.[v]
Keep in mind that Carhart’s findings were all pretax. Thus, the results of actively managed funds in his research would have been even worse because of the expenses incurred in portfolio turnover. Focus Funds
Many people attribute the failure of mutual funds to being “over-diversified.” The reasoning behind this logic is that by owning so many securities, the value of the manager’s best ideas are diluted.[vi] Thus, focus funds were created by the mutual fund industry. Focus funds hold fewer stocks than a typical mutual fund. The managers concentrate the risk in hope of better returns. If the market is inefficient, the managers of these funds should be able to deliver alpha.
In a research report titled “Security Concentration and Active Fund Management: Do Focused Funds Offer Superior Performance”, Travis Sapp and Xuemin Yan attempt to find out if focused fund do indeed deliver alpha. From their examinations they found that focused funds significantly underperform diversified funds. Focused fund underperformance can be explained by agency and liquidity problems.[vii] If markets were inefficient, skilled managers of these funds should be able to outperform diversified funds. However, focused funds are liquidated or sold to another company at much higher percentage than diversified funds.
Figure 2: Sapp, Travis and Xuemin Yan. "Security Concentration and Active Fund Management: Do Focused Funds Offer Superior Performance?" The Financial Review (2008).
Another explanation for the failure of focus funds is that while the market may not be perfectly efficient, it is sufficiently efficient that after expenses it is difficult to exploit any pricing errors.
Bond Funds
The evidence for an efficient market is just as compelling when looking at actively managed bond mutual funds. Two studies demonstrated that bond funds didn’t provide any extra value to investors. “The Performance of Bond Mutual Funds” by Christopher Blake, Edwin Elton and Martin Gruber claimed that the average actively managed bond fund underperformed its benchmark by .75 to .95 percent annually. A 1994 article in Fortune magazine reported that only 16% of 800 bond funds beat their benchmark over a 10 year period.[viii]
Marlena Lee of Dimensional Fund Advisers (DFA) performed her own study. She studied the performance of 2,353 bond funds from 1991-2008. She found out that actively managed bond funds underperform by an amount roughly equivalent to fees. She also discovered that there was no evidence of positive after-cost expected alphas, even in the top percentile of funds. Finally, she noted that in 2008 investors in bond funds collectively lost about $1.4 billion.[ix]
Interest rate forecasting is the only way an active manager can add value in any significant way. To the chagrin of interest-rate-crystal-ball-owners out there, they consistently find that their crystal ball is completely foggy when trying to predict future interest rates. There is no evidence of any ability at all to forecast future interest rate levels.[x]
In our next article we will conclude our findings on the performance of actively managed mutual funds.
Sources: [i] Swedroe, Larry E. The Quest or Alpha. Hoboken: John Wiley & Sons Inc., 2011
[ii] http://www.investopedia.com/terms/s/survivorshipbias.asp
[iii] Mark Carhart, Jennifer N Carpenter, Anthony W. Lynch, and David K. Musto, "Mutual Fund Survivorship," Review of Financial Studies, Winter 2002
[iv] Swedroe, Larry E. The Quest or Alpha. Hoboken: John Wiley & Sons Inc., 2011
[v] Carhart, Mark. "On Persistence in Mutual Fund Performance." The Journal of Finance (1997).
[vi] Swedroe, Larry E. The Quest or Alpha. Hoboken: John Wiley & Sons Inc., 2011
[vii] Sapp, Travis and Xuemin Yan. "Security Concentration and Active Fund Management: Do Focused Funds Offer Superior Performance?" The Financial Review (2008).
[viii] Swedroe, Larry E. The Quest or Alpha. Hoboken: John Wiley & Sons Inc., 2011
[ix] Lee, Marlena I. "Is There Skill among Active Bond Managers." (2009).
[x] Swedroe, Larry E. The Quest or Alpha. Hoboken: John Wiley & Sons Inc., 2011