In the ongoing debate between the "market beaters" and the "evidence based investors" ( i.e. the indexers - yes, those whom detractors call passive investors), one issue that continually comes up is whether picking market beating mutual funds can be done.
The first place most people turn for superior performance is the track record. This, however, according to the evidence, is futile. Simply, the best performers of the recent past turn out to be not the best performers going forward. In other words, there is a lack of consistency among those with the best past records.
DIY Investor's Theory
But why wouldn't the best performing funds of the recent past continue to produce exceptional performance going forward? After all, aren't they the smartest, hardest-working, generally most skilled investors among their peers? As DIY Investor has pondered this, he has recalled personal experience which he has described previously. In the early 1980s, DIY Investor managed a small Treasury bond fund ($15 million) for an insurance company which, by a series of trades in a volatile market, produced a spectacular return relative to its index. In fact, the fund was #3 across the U.S., in its category, as listed in Pensions & Investment Age for the quarter. Its performance got DIY Investor interviewed in the article that listed performance of institutional managers and attracted attention.
To understand DIY Investor's thinking at that point, it is useful to appreciate that the goal of the institutional manager is to produce an outstanding longer-term record. A 3-year record in the bond market, for example, that is .8% above the index ( for example, if the index return is 5.0% annualized and the manager's return is 5.8% annualized) attracts institutional money to the funds. How did this affect his thinking after the exceptional 3-month performance? DIY Investor figured that all he had to do was match the market return over the next couple of years and it would produce an exceptional long-term track record . His incentive for taking risk relative to the benchmark had been reduced.
Think about that top-performing mutual fund you were looking at yesterday that has beat the S&P 500 by x% over the last 5 years. Why should it take risk to outperform the market going forward?
There are other reasons, of course, for why the market beaters won't persist in spectacular performance; but this subtle impact of basically mismatched information is one that gets overlooked, in DIY Investor's opinion. Again, the fund manager has a different incentive than the fund buyer. The fund manager, after a period of exceptional performance, is content to match the index ( and charge active management fees); and the fund buyer thinks he or she is buying an investment approach and expertise that produced exceptional performance.
The underlying reasons are interesting; but, in the end, the evidence on track record performance is what matters. A neat and sophisticated analysis along these lines has been done by the calculating investor in examining subsequent performance of the top 5 Forbes Honor Roll funds in 2005. He examined the next 5 years and found "...an investor who invested an equal amount in each of these Top 5 Honor Roll funds would have underperformed the VTI index by more than 4% over the 5-year period." But he went further and did a risk-adjusted return analysis based on the Fama-French 3 Factor Model and found that only one fund outperformed ( had a positive alpha) on a risk-adjusted basis.
DIY Investor continues to question why people would put their retirement savings in the hands of those who charge excessive fees, and seek to "beat the market" when the evidence clearly shows that most people lose in this endeavor. Using track records to identify "market beaters" is clearly without merit.
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