Reviewed February 2021
ACTIVELY MANAGED MUTUAL FUNDS
Abstract: Extensive research indicates that past mutual fund performance doesn't predict future performance, that "hot" mutual fund outperformance cannot be determined in advance, that mutual fund rating services offer little profitable insight when selecting funds, that active mutual funds do not do better in bear markets than passive and index funds and that only one variable predicts future mutual fund performance to some degree, the expense ratio for the fund. This article was first written in 2000 and since then evidence for the advantage of passive and index funds over actively managed funds has continued to accumulate. Passive and index fund management is clearly superior to active fund management in producing returns for investors.
PAST MUTUAL FUND PERFORMANCE DOESN'T PREDICT FUTURE PERFORMANCE. Extensive, oft-repeated studies of five, ten, and twenty year track records for mutual funds find that there is no useful statistical relationship whatsoever between a fund's past performance and its future performance. One Morningstar study found that of 452 domestic equity funds in their database that had existed for 20 years only 3% outperformed their respective indexes. This doesn't take into account survivorship bias which would have reduced this percentage even further. Funds that did not survive were deleted from the data base and funds that survived for 20 years were obviously the better performing funds in the sample.
DFA examined survivorship bias for July 2004 through June 2009. DFA found that on average 5.7% of the actively managed fund universe disappeared each year. DFA also found that 63% to 90% of active equity funds and 93% to 100% of active fixed income funds underperformed their matched indexes with underperformance depending upon asset class. Only about 1.4% of actively managed funds outperformed their benchmark over the five year period. One Morningstar study found that of the 248 stock funds receiving Morningstar's (highest) five star rating in January 2000, only four, or 1.6%, kept that rank after ten years (12-31-09). Few retail investors would have missed the financial media's coverage of fund manager Elaine Garzelli's forecast of the Crash of 1987 since it was widely covered in the financial press. She predicted the Fall 1987 crash one week before it occured, a spectacular prediction, and money streamed into her fund. One year later in 1988 her fund lost 13.1% and lagged the market by 29.7%. In her fund's six years of full operation before closure it trailed the S&P 500 by 9.6% annually. Yet, the financial media continues to present new outperforming investment managers to the retail investment public and rarely reports on their subsequent performance.
Past performance doesn't predict future performance though there is some weak evidence that outperforming funds in one year tend to slightly outperform the next year. It is of little practical use to investors because of the costs involved in trading funds. Yet, mutual fund rating systems and investors continue to focus on past fund performance as a primary criterion for recommending funds. This is simply looking backward to predict an unpredictable future. Morningstar provides analysis and rankings of mutual funds primarily based on that past performance. And, the financial community boasts about and promotes top rated Morningstar funds and investors move money into them in far greater amounts than lesser ranked Morningstar funds.
"HOT" MUTUAL FUND MANAGERS CAN'T BE CHOSEN IN ADVANCE. There's no evidence that outperforming mutual funds can be chosen in advance. This makes sense since past fund performance doesn't predict future performance. A sixteen year study of Forbes recommended "Honor Roll" Funds found that they substantially underperformed the S & P 500 index. A New York Times contest pitted five prominent experienced mutual fund advisors, including the publisher of Morningstar, against the S & P 500 for a three year period. The experts underperformed the S&P by an average 5% per year. An update on the study in July of 1999 reported that the leader of the five fund pickers had managed a gain of 157.9% over the six year period through mid-1999. The S & P 500 rose about 250%.
FUND RATING COMPANIES ADD LITTLE OR NO VALUE. Commercial fund rating systems appear to be of little value. Research on Morningstar's track record indicates that investing in top rated five-star funds produced future underperformance for subsequent one and three year periods, not superior performance, for both stock and bond funds. Weston Wellington of DFA (April 2004) looked at a curious anomaly in Morningstar's rating of three DFA funds. Morningstar rated one DFA fund two stars, one three stars, and one four stars. The funds were all virtually identical in the securities they held. It turns out that Morningstar's rating scheme is dependent on the period of time a fund has been in existence and the three funds started at different times so different numbers resulted. Investors may be further mislead about fund performance because Morningstar's exclusion of loads, sales charges, and taxes when reporting fund performance increases apparent returns. However, these factors very significantly reduce returns in actively managed load funds when compared with passive and index funds.
Mutual fund rating services seem to know that their ratings and rankings systems shouldn't be used to predict fund performance or select funds but downplay that fact. It is doubtful they would have a marketplace for their publications if they didn't offer predictions. They make their living selling this information. Morningstar's User's Manual contains only a few underemphasized disclaimers: "It's important that investors not place too much emphasis on this rating when evaluating funds", and "a rating is neither a predictive measure nor a "buy/sell" recommendation". That seems pretty clear. Morningstar isn't in the prediction business. Yet, many investment advisors and mutual fund companies select, promote, and sell funds emphasizing high Morningstar "star" ratings.
On 10-25-2017 the Wall Street Journal published a detailed critique entitled "The Morningstar Mirage". In it, they critically examined the widely held assumption that the number of stars Morningstar gives to a mutual fund is a good guide to its future performance. According to Morningstar some 250,000 financial advisors rely upon Morningstar's analyses and the industry ecosystem for buying and selling mutual funds revolves around it with many mutual fund companies advertising their Morningstar ratings. The Journal's analysis found that investors put new money into five star funds 69% of the months they held that rating compared to only 29% of one star funds. Morningstar acknowledged its ratings can influence demand for funds with recent outperformance.
Morningstar also says it never claimed its ratings suggest how funds will perform in the future but says its ratings are a first stage screen to help identify funds with good long term performance histories, it's a starting point, and then says that its star ratings point investors to funds "likelier to outperform in the future". Morningstar rode the mutual fund wave of a 40x gain in US equity prices from 1982 through 2016. It went public in 2005. Its star ratings cover 10,800 mutual funds across almost 39,000 share classes. In US domestic equity funds that had merited a maximum five star rating a mere 10% earned five stars for the next three years and only 6% for the next ten years. The WSJ concludes, "that means a five star rating for equity funds was no more an omen of success than it was one of failure". Morningstar's ratings of taxable bond funds was only a little better with 16% of five star funds maintaining that rating after five years.
ACTIVELY MANAGED FUNDS DON'T OUPERFORM PASSIVE AND INDEX FUNDS IN BEAR MARKETS. During bear markets actively managed funds frequently promote the idea that they'll protect investors and avoid the losses indexes produce since indexes merely track a declining market. Supposedly, active managers possess skill in knowing when to profitably move into and out of markets and asset classes. There is no evidence to support this claim. In 2008, a very poor year for equities, Morningstar data show that actively managed funds lost 1.4% more than index funds. In the early 2000's DFA's globally diversified equity portfolios dramatically outperformed active funds. See "Risk and Return" elsewhere on our website.
ACTIVE MUTUAL FUNDS ARE MORE EXPENSIVE THAN PASSIVE AND INDEX FUNDS. Extensive research indicates that after management fees, trading costs, and other expenses the average actively managed equity fund underperforms its respective index benchmark by about 1% to 2.5% per year depending upon asset class and the average actively managed fixed income fund underperforms by about 1% per year. The average actively managed equity fund has an expense ratio around 1.3% versus between 0.04% and 0.45% for passive and index funds depending upon asset class. The average actively managed fixed fund has an expense ratio around 1% versus 0.04% to 0.3% for passive and index funds. Expenses significantly reduce returns in actively managed funds.
INVESTORS ARE ENCOURAGED TO MOVE IN AND OUT OF ACTIVE MUTUAL FUNDS BASED ON RECENT PERFORMANCE. Repeated studies done by Dalbar, an independent research group, have found that broker advised fund investors and investors self-managing their own mutual fund accounts dramatically underperform the S & P 500 index. In one study Dalbar found that the average stock fund investor earned annual returns of only 2.6% for the seventeen year period from 1984 through 2002 while the S & P 500 index averaged 12.2% per year and one month C.D.'s returned 5.8%. Investors as a group would have done far better avoiding the risk and volatility in equity markets and simply buying C.D.'s at the bank. From 1984 through 1998 the average fixed income fund investor received an annualized return of 6.33% while the long-term government bond index yielded far more, 12.76% annually.
Paul Farrell on Marketwatch (4-10-12) mentions a study prepared for mutual fund industry insiders by the Fund Research Corp., FRC, "Predicting Mutual Fund Performance II". FRC studied funds in five asset classes, US equities, international equities, corporate bonds, government bonds, and municipal bonds. They tested ten variables often used to predict mutual fund performance and select mutual funds likely to outperform. These included past performance, Morningstar ratings, expense ratios, asset size, and four risk/volatility measures, alpha, beta, standard deviation and the Sharpe ratio. FRC concluded that only one of these variables predicted future mutual fund performance-the expense ratio. Passive and index mutual funds offer, by far, the lowest expense ratios.
CONCLUSION: Since research clearly shows that active mutual fund performance cannot be determined in advance and that active managers significantly underperform passive and index portfolios over longer time-frames investors should avoid active fixed income and equity funds and rating and ranking systems for selecting them. Real investors in real fund portfolios do significantly worse than the advertised numbers so choosing and/or trading actively managed mutual funds isn't a wise choice. The far better choice is to employ a buy and hold strategy with passive and index portfolios for both equity and fixed income investing and that's what EAM does.