Every so often a new study surfaces, which promotes the virtues of index investing vs. the use of “old fashioned” mutual funds. Here’s the latest titled “Cast your fortunes with index funds.” Let’s listen in:
Investors who continue to send money to actively managed mutual funds in the hope that managers will be able to beat less-costly index funds are going to lose out almost all of the time, a new study finds.
The study by two noted finance professors claims that it’s effectively impossible to tell whether a manager has performed well due to luck or skill — which means that it’s also impossible for an investor to know for sure.
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In other words, stop trying to pick market-beating managers — instead, choose index-linked funds.
Fama and Kenneth French, professor of finance at Dartmouth College Tuck School of Business, ran 10,000 simulations of what investors could expect from actively managed funds. They found that outside the top 3% of funds, active management lags results that would be delivered due simply to chance.
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Fama and French’s study, “Luck Versus Skill in the Cross Section of Mutual Fund Returns,” looked at the returns of 3,156 U.S. stock mutual funds from January 1984 to September 2006. It included mutual funds that were liquidated and any fund launched before September 2001 that reached more than $5 million in assets. Find a copy of the report at the Social Science Research Network.
The fact that some funds beat the simulations does suggest that by picking the right funds investors can consistently outperform the market. But there’s just one problem, according to the professors: “[T]he good funds are indistinguishable from the lucky bad funds that land in the top percentiles.”
That leaves picking the right fund a matter of guesswork. So even if investors stick with the top performers, they’re running a risk because the manager’s good results could be based on luck.
“You’re taking the chance of being with somebody’s who’s not just lucky, but actually bad,” added Fama.
The presence of both good funds and lucky bad funds means it’s likely that investors focused on top performers will end up with returns close to the market.
“In other words, going forward we expect that a portfolio of low-cost index funds will perform about as well as a portfolio of the top three percentiles of past active winners, and better than the rest of the active fund universe,” wrote the professors.
Although it is not specifically mentioned, the entire study is based on buy and hold investing. If that were my mode of operation, sure, I might decide on low cost index funds as well.
Personally, I think making the case of a bad fund manager being lucky is just being plain silly. A “good” fund manager may have been able to pick better stocks in a bull market than a “bad” fund manager, but when a bear market strikes, just as we’ve seen in 2000 and 20008, both will lose money at an alarming rate.
The point that is overlooked in this study is that all equity funds (unless they’re bear market funds) and indexes are geared to work only in a bullish environment, and all will fail miserably at varying degrees in down markets.
I believe that both, mutual funds and ETFs, should be selected based on which might be most appropriate at the time an investment is made. A quick check of my data base M-Index rankings revealed that currently 29 no load mutual funds rank higher than 13 on the scale, while only 12 ETFs of the same orientation qualified.
Rather than trying to continue with study after study to try to come up with results that favor indexes over mutual funds, the case should be made for using an investment approach that keeps investors out of bear markets and invested only when the trend is bullish. It would avoid a lot of heartaches and end the discussion as to whether index funds are superior to mutual funds.
Comments 4
The problem Uli is that ALL such studies are based on buy and hope investing. The last 25 years still includes the period from the mid 80's. Someday soon 25 year period is going to provide sorry returns and excuses for buy and holders.
I do agree that most active managers should be ashamed of themselves. However, investors also share some responsibility. When they chose their car or their flat screen TV, investor are wise and frugal shoppers. Why then when it comes to investing do they not use their due diligence? It is because everyone believes investing is genius and genius is scarce and to be found only with asset managers.
Frankly I'm not sure why you do what you do for free. And I shamelessly ask you two things. Keep doing it for people like me who cannot afford your services. And ignore such articles. If more buy and holders stop being buy and holders, you and us will lose our edge. We need these buy and holders so we can exit our positions by selling to them when they DCA into their holdings every month.
Is it too late to buy in to the current market? If someone has a new amount of cash (401k rollover, inheritance, etc.) should they wait to enter the market?
I addressed that topic in a recent post called "New Money." You can read it here: http://thewallstreetbully.blogspot.com/2009/12/new-money.html
Ulli…
There are three kinds of lies:
1. Lies
2. Damn lies
3. Statistics
One need only look at Bruce Berkowitz at Fairholme, Donald Yacktman at the Yacktman funds, Michael Cuggiano at Permenant Portfolio, or Berkshire Hathaway. Then compare the actively managed fund to some BROADLY based DOMESTIC ETF (SPY, DIA, QQQ, etc.) There are dozens of other broadly based domestic ETFs. I believe ALL of them are out peformed by good funds. You could get rich quickly buying any of the above mentioned funds, as well as Ken Heebner at CGM, after they have had a long period of UNDERPERFORMANCE. They know what they are doing and their style and picks will come back into vogue sooner or later.