In our last post, we talked about the first of three key problems with mutual fund advertisements:
They never showcase the poor performing funds.
As a result, the mutual fund company who paid for the ad is only telling part of the story.
Today, we are going to discuss the other two problems:
1) When it comes to the history of the typical mutual fund or fund manager, past performance is no guarantee of future results
Extensive research has shown that after properly accounting for risk, there is no meaningful persistence in the performance of a given mutual fund or fund manager.
That’s why every mutual fund ad is required to contain a disclaimer that says something like: “past performance is not a guarantee of future results.”
In other words, a “track record” by itself tells you very little about what you can expect going forward from the fund.
Instead, a smart investor must understand the characteristics of a fund that contributed to (or detracted from) its returns.
Specifically, the performance of a fund can be broken down according to its exposure to the following risk factors or premiums:
- Market (stocks vs. bonds)
- Size (small stocks vs. large stocks)
- Price/value (value stocks vs. growth stocks)
- Term (long-term bonds vs. short-term bonds)
- Credit (corporate bonds vs. government bonds)
There are other risk factors that can be considered, but for simplicity sake, these are the most important.
I won’t break down each of these in detail, but this is the important takeaway:
Each of these types of risks can be accessed through very low cost investment vehicles, such as an index fund, ETF, or other passive structure.
Thus, an actively managed mutual fund should not be given credit for returns that are simply a function of exposures to risk.
More importantly, once you account for each of these risk factors, the outperformance or “alpha” of a typical mutual fund relative to its benchmark tends to vanish.
What does this mean for an investor?
There are many things a fund should be judged upon, but standalone performance is not one of them.
2) Morningstar ratings measure past performance and do a mediocre job of predicting the future
Again, the past is not prologue.
In fact, Morningstar themselves performed an extensive analysis into the predictive power of their star ratings system, as well as other factors that could be used to make intelligent mutual fund investment decisions.
What did they find?
It wasn’t star ratings, or returns, or any other metric the typical investor or advisor uses to pick funds.
Rather, it was expense ratios.
To quote Russel Kinnel, Director of Fund Research and Editor at Morningstar, who authored the report:
“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”
Why is this so?
Simple. Because buying and selling stocks in an attempt to beat the market is a negative sum game.
In the aggregate, investors earn the market return, less the fees and expenses they incur (Bill Sharpe’s The Arithmetic of Active Management does a great job explaining this).
Actively managed mutual funds that try to beat the market are expensive and incur a lot of trading costs.
These costs detract from their returns on a dollar for dollar basis.
On the other hand, the typical index fund has very low costs and minimal turnover.
This means the fund captures the market return less a much lower cost than its actively managed counterpart.
Thus, although some actively managed funds will beat the market, the vast majority will not.
Furthermore, trying to identify the funds that will beat the market in advance is virtually impossible.
So next time you see an ad touting the great performance of a mutual fund, ignore it. It’s not even worth the paper it was printed on.