Mutual Fund Investment Performance A First Look

We noted earlier that one of the benefits of mutual funds for the individual investor is the ability to delegate management of the portfolio to investment professionals. The investor retains control over the broad features of the overall portfolio through the asset allocation

118 PART I Introduction decision: Each individual chooses the percentages of the portfolio to invest in bond funds versus equity funds versus money market funds, and so forth, but can leave the specific security selection decisions within each investment class to the managers of each fund. Shareholders hope that these portfolio managers can achieve better investment performance than they could obtain on their own.

What is the investment record of the mutual fund industry? This seemingly straightforward question is deceptively difficult to answer because we need a standard against which to evaluate performance. For example, we clearly would not want to compare the investment performance of an equity fund to the rate of return available in the money market. The vast differences in the risk of these two markets dictate that year-by-year as well as average performance will differ considerably. We would expect to find that equity funds outperform money market funds (on average) as compensation to investors for the extra risk incurred in equity markets. How then can we determine whether mutual fund portfolio managers are performing up to par given the level of risk they incur? In other words, what is the proper benchmark against which investment performance ought to be evaluated?

Measuring portfolio risk properly and using such measures to choose an appropriate benchmark is an extremely difficult task. We devote all of Parts II and III of the text to issues surrounding the proper measurement of portfolio risk and the trade-off between risk and return. In this chapter, therefore, we will satisfy ourselves with a first look at the question of fund performance by using only very simple performance benchmarks and ignoring the more subtle issues of risk differences across funds. However, we will return to this topic in Chapter 12, where we take a closer look at mutual fund performance after adjusting for differences in the exposure of portfolios to various sources of risk.

Here we use as a benchmark for the performance of equity fund managers the rate of return on the Wilshire 5000 Index. Recall from Chapter 2 that this is a value-weighted index of about 7,000 stocks that trade on the NYSE, Nasdaq, and Amex stock markets. It is the most inclusive index of the performance of U.S. equities. The performance of the Wilshire 5000 is a useful benchmark with which to evaluate professional managers because it corresponds to a simple passive investment strategy: Buy all the shares in the index in proportion to their outstanding market value. Moreover, this is a feasible strategy for even small investors, because the Vanguard Group offers an index fund (its Total Stock Market Portfolio) designed to replicate the performance of the Wilshire 5000 index. The expense ratio of the fund is extremely small by the standards of other equity funds, only .25% per year. Using the Wilshire 5000 Index as a benchmark, we may pose the problem of evaluating the performance of mutual fund portfolio managers this way: How does the typical performance of actively managed equity mutual funds compare to the performance of a passively managed portfolio that simply replicates the composition of a broad index of the stock market?

By using the Wilshire 5000 as a benchmark, we use a well-diversified equity index to evaluate the performance of managers of diversified equity funds. Nevertheless, as noted earlier, this is only an imperfect comparison, as the risk of the Wilshire 5000 portfolio may not be comparable to that of any particular fund.

Casual comparisons of the performance of the Wilshire 5000 index versus that of professionally managed mutual fund portfolios show disappointing results for most fund managers. Figure 4.3 shows the percentage of mutual fund managers whose performance was inferior in each year to the Wilshire 5000. In more years than not, the Index has outperformed the median manager. Figure 4.4 shows the cumulative return since 1971 of the Wilshire 5000 compared to the Lipper General Equity Fund Average. The annualized compound return of the Wilshire 5000 was 14.01% versus 12.44% for the average fund. The 1.57% margin is substantial.

Figure 4.3 Percent of equity mutual funds outperformed by Wilshire 5000 Index.

I I I I I I I I I I I I I I I I I I I I I I I I I I I I 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 7777777788888888889999999999 9999999999999999999999999999

Source: The Vanguard Group.

Figure 4.4 Growth of $1 invested in Wilshire 5000 Index versus Average General Equity Fund.

Wilshire 5000

Total Return (%)

Cumulative Annual

Wilshire 5000 Average fund

4,379 14.01 2,895 12.44

Average fund

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Source: The Vanguard Group.

To some extent, however, this comparison is unfair. Actively managed funds incur expenses which reduce the rate of return of the portfolio, as well as trading costs such as commissions and bid-ask spreads that also reduce returns. John Bogle, former chairman of the Vanguard Group, has estimated that operating expenses reduce the return of typical

120 PART I Introduction managed portfolios by about 1% and that transaction fees associated with trading reduce returns by an additional .7%. In contrast, the return to the Wilshire index is calculated as though investors can buy or sell the index with reinvested dividends without incurring any expenses.

These considerations suggest that a better benchmark for the performance of actively managed funds is the performance of index funds, rather than the performance of the indexes themselves. Vanguard's Wilshire 5000 fund was established only recently, and so has a short track record. However, because it is passively managed, its expense ratio is only about 0.25%; moreover because index funds need to engage in very little trading, its turnover rate is about 3% per year, also extremely low. If we reduce the rate of return on the index by about 0.30%, we ought to obtain a good estimate of the rate of return achievable by a low-cost indexed portfolio. This procedure reduces the average margin of superiority of the index strategy over the average mutual fund from 1.57% to 1.27%, still suggesting that over the past two decades, passively managed (indexed) equity funds would have outperformed the typical actively managed fund.

This result may seem surprising to you. After all, it would not seem unreasonable to expect that professional money managers should be able to outperform a very simple rule such as "hold an indexed portfolio." As it turns out, however, there may be good reasons to expect such a result. We explore them in detail in Chapter 12, where we discuss the efficient market hypothesis.

Of course, one might argue that there are good managers and bad managers, and that the good managers can, in fact, consistently outperform the index. To test this notion, we examine whether managers with good performance in one year are likely to repeat that performance in a following year. In other words, is superior performance in any particular year due to luck, and therefore random, or due to skill, and therefore consistent from year to year?

To answer this question, Goetzmann and Ibbotson3 examined the performance of a large sample of equity mutual fund portfolios over the 1976-1985 period. Dividing the funds into two groups based on total investment return for different subperiods, they posed the question: "Do funds with investment returns in the top half of the sample in one two-year period continue to perform well in the subsequent two-year period?"

Panel A of Table 4.4 presents a summary of their results. The table shows the fraction of "winners" (i.e., top-half performers) in the initial period that turn out to be winners or losers in the following two-year period. If performance were purely random from one period to the next, there would be entries of 50% in each cell of the table, as top- or bottom-half performers would be equally likely to perform in either the top or bottom half of the sample in the following period. On the other hand, if performance were due entirely to skill, with no randomness, we would expect to see entries of 100% on the diagonals and entries of 0% on the off-diagonals: Top-half performers would all remain in the top half while bottom-half performers similarly would all remain in the bottom half. In fact, the table shows that 62.0% of initial top-half performers fall in the top half of the sample in the following period, while 63.4% of initial bottom-half performers fall in the bottom half in the following period. This evidence is consistent with the notion that at least part of a fund's performance is a function of skill as opposed to luck, so that relative performance tends to persist from one period to the next.4

3 William N. Goetzmann and Roger G. Ibbotson, "Do Winners Repeat?" Journal of Portfolio Management (Winter 1994), pp. 9-18.

4 Another possibility is that performance consistency is due to variation in fee structure across funds. We return to this possibility in Chapter 12.

Table 4.4 Consistency of Investment Results

CHAPTER 4 Mutual Funds and Other Investment Companies 121

CHAPTER 4 Mutual Funds and Other Investment Companies 121

Table 4.4 Consistency of Investment Results

Initial Period Performance

Successive Period Performance Top Half Bottom Half

A. Goetzmann and Ibbotson study

Top half

62.0%

38.0%

Bottom half

36.6%

63.4%

B. Malkiel study, 1970s

Top half

65.1%

34.9%

Bottom half

35.5%

64.5%

C. Malkiel study, 1980s

Top half

51.7%

48.3%

Bottom half

47.5%

52.5%

Sources: Panel A: William N. Goetzmann and Roger G. Ibbotson, "Do Winners Repeat?" Journal of Portfolio Management (Winter 1994), pp. 9-18; Panels B and C: Burton G. Malkiel, "Returns from Investing in Equity Mutual Funds 1971-1991," Journal of Finance 50 (June 1995), pp. 549-72.

Sources: Panel A: William N. Goetzmann and Roger G. Ibbotson, "Do Winners Repeat?" Journal of Portfolio Management (Winter 1994), pp. 9-18; Panels B and C: Burton G. Malkiel, "Returns from Investing in Equity Mutual Funds 1971-1991," Journal of Finance 50 (June 1995), pp. 549-72.

On the other hand, this relationship does not seem stable across different sample periods. Malkiel5 uses a larger sample, but a similar methodology (except that he uses one-year instead of two-year investment returns) to examine performance consistency. He finds that while initial-year performance predicts subsequent-year performance in the 1970s (see Table 4.4, Panel B), the pattern of persistence in performance virtually disappears in the 1980s (Panel C).

To summarize, the evidence that performance is consistent from one period to the next is suggestive, but it is inconclusive. In the 1970s, top-half funds in one year were twice as likely in the following year to be in the top half as the bottom half of funds. In the 1980s, the odds that a top-half fund would fall in the top half in the following year were essentially equivalent to those of a coin flip.

Other studies suggest that bad performance is more likely to persist than good performance. This makes some sense: It is easy to identify fund characteristics that will predictably lead to consistently poor investment performance, notably high expense ratios, and high turnover ratios with associated trading costs. It is far harder to identify the secrets of successful stock picking. (If it were easy, we would all be rich!) Thus the consistency we do observe in fund performance may be due in large part to the poor performers. This suggests that the real value of past performance data is to avoid truly poor funds, even if identifying the future top performers is still a daunting task.

CONCEPT CHECK ^ QUESTION 4

Suppose you observe the investment performance of 200 portfolio managers and rank them by investment returns during the year. Of the managers in the top half of the sample, 40% are truly skilled, but the other 60% fell in the top half purely because of good luck. What fraction of these top-half managers would you expect to be top-half performers next year?

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