Chapter 9

Knowledgeable observers realize that the central task of investing is to gain the highest possible portion of the long-run return achieved by the class of financial assets in which they invest. But they recognize and accept that the portion will be less than 100 percent. As I have indicated in Chapter 4, a market index fund can provide 99 percent of the annual returns earned by its stock market benchmark, while the average actively managed stock fund can be expected to provide about 85 percent. While the future relative returns of managed funds are uncertain, it is difficult to imagine that they will rise to anywhere near 99 percent. Low-cost index funds, on the other hand, are almost certain to reach the 98 to 99 percent level, consistently over time.

As I noted earlier, even industry leaders are coming to recognize these realities, explicitly acknowledging (at least in one case) that “the average fund can never outperform the market.” In fact, even those whose business is the promotion of actively managed funds cannot ignore these two poignant realities of the marketplace: (1) investors, as a group, do not, cannot, and will not beat the market, and (2) the overwhelming odds are against any particular mutual fund’s doing so consistently over an investment lifetime. The real world of investing is not at all like Garrison Keillor’s mythical Lake Wobegon, where “all of the children are above average.”

Recognizing these powerful odds against any individual fund’s outpacing an unmanaged index, the mutual fund industry has implicitly conceded this point. Reflecting the concession, much of the industry is engaged in a hell-bent mission to take hold of the finest instrument ever created for long-term investing and transform it into a vehicle for intermediate-term—and even short-term—speculation.

Intelligent investors must accept the fact that, over time, the fund (or funds) they select, irrespective of past performance, will inevitably revert toward the mean. But the mean here is defined as the market mean reduced by the costs the fund incurs—advisory fees, operating expenses, and marketing costs (in all, the expense ratio)—plus the cost of buying and selling portfolio securities (transaction costs). In the world of mutual funds, as we’ve seen, these costs are extremely high. The annual expense ratio of a median equity fund is now 1.5 percent, and rising. Transaction costs are difficult to quantify with precision, but with the high portfolio turnover rates generated in mutual funds an estimate of 0.5 percent to 1 percent annually hardly seems excessive. Current all-in costs, then, can be conservatively estimated at upward of 2 percent per year.

Given these realities, the search for the holy grail of market-beating long-term returns has been every bit as frustrating to fund managers and fund investors in the twentieth century—and will surely be so in the twenty-first century—as the search for the Holy Grail of the Last Supper was to the legendary knights of King Arthur’s Round Table in the sixth century.

The Equity Fund Record

Let’s first examine the records of equity mutual funds in what I’ll call the modern era. I’ll use the period since the beginning of the great U.S. bull market in stocks, from August 1982 to mid -1998. This period is particularly relevant because it embraces the time during which equity fund assets became the largest pool of assets, holding more than 21 percent of the value of the U.S. stock market, and during which mutual fund expense ratios and portfolio turnover activity rose to the highest levels in history. Over this 16-year span, the annual returns of those equity mutual funds that survived the period averaged 16.5 percent before taxes, providing 87 percent of the return of the total stock market, as measured by the 18.9 percent returns on the all-market Wilshire 5000 Equity Index.^s Given the rise in fund costs, it seems certain that this gap between fund returns and market returns will widen in the future.

These undeniable facts about fund returns, fund costs, and the relevance of past fund records have led to the boom in index funds today. If you can’t beat the market—no one speaks of meeting the market—why not join it? An all-market index fund, operated at a total cost of 0.2 percent (one-tenth of the industry norm), would have provided an annual return of 18.7 percent, or nearly 99 percent of the total market return during the same period.

The comparison of 99 percent of annual market return for an index fund and 87 percent for a managed fund, as we now know, conceals a much larger gap than merely 12 points. The terminal value of the initial investment of $10,000 in the index fund on August 2, 1982, would have been $153,100; the terminal value of the same investment, for the same time period, in a traditionally managed active fund would have been $113,700. Thus, the index fund provided 97 percent of the accumulated growth in value of the investment in the index itself while the average managed fund provided only 70 percent of its accumulated growth. In Chapter 14, I will explore in greater detail the mathematics that explain why the managed fund shortfall rises so steeply over time. For now, let’s just call it “the tyranny of compounding.”

If these numbers frighten you, consider that, in all probability, you “ain’t seen nothin’ yet.” Assuming only that the bull-market tree doesn’t grow to the sky and the stock market gives a more modest account of itself, the performance gap will get larger. For example, let’s hold costs constant and take stock market returns down to, say, 8 percent annually over 15 years. The results would be a net return of 7.8 percent for the index fund (98 percent of the market return) and 6 percent for the managed equity fund (75 percent). At the end of 15 years, the $10,000 investment would be valued at $30,900 in the index fund versus $24,000 in the managed equity fund. Now, the accumulated growth of the index fund represents 96 percent of the growth in the index investment, while the managed fund share tumbles to 64 percent. Tyranny, as it were, has increased the cumulative performance gap from 27 percentage points in the past bull-market era to 32 percentage points in what may well be a more realistic depiction of the foreseeable future. But whatever the future holds, the wide gap between managed fund returns and market index returns is not a very happy prospect for the fund industry. It means that managed mutual funds, accepted at least implicitly by investors as the holy grail of high performance during most of the great bull market, will again fail to meet the test of time.

TEN YEARS LATER

Equity Fund Record

Bringing the comparison of equity fund returns to stock market returns up to date over the 27-year span from August 1982 through mid-2009, the annual return on the average fund came to 9.0 percent, a shortfall of two percentage points compared to the 11.0 percent return of the U.S. Total Stock Market Index. Given the power of compounding returns over a much longer time period, the terminal values of an initial investment of $10,000 in each have risen sharply: $102,450 for the average equity fund versus $167,000 for the Total Stock Market Index.

The annual fund return was equal to 82 percent of the market return (a smaller margin than I expected). But the cumulative fund return was equal to but 59 percent of the market return, even smaller than the 70 percent capture rate that I cited in the previous edition. That increase in the performance gap was hardly surprising. In fact, in the previous edition, I wrote, “Assuming only that the bull-market tree doesn’t grow to the sky and the stock market gives a more modest account of itself, the performance gap will get larger.” Well, the tree didn’t grow to the sky (to say the least), and the gap in favor of the index fund did get larger.

Enter the Index Fund

My study of historical performance relationships similar to these (although considerably less unfavorable to the funds), almost 25 years ago, encouraged me to start the fund industry’s first market index mutual fund, modeled on the Standard & Poor’s Composite Stock Price Index, as I chronicled in Chapter 5, “On Indexing.” After a shaky start and minuscule assets, the Vanguard 500 Index Fund turned on its jets and became both an artistic and a commercial success.

Despite its initially chilly reception, the index fund now commands the attention of executives throughout the mutual fund industry. Although uncopied—even shunned—for a full decade, the first index fund has now been joined by some 140 competitive index funds. A few have been formed by missionaries (or converts, and “there’s no one more religious than a convert ”), but most by opportunistic no-load firms, eating crow and dragged—kicking and screaming—into the fray by the institutional 401(k) savings plan market. Some have reasonable expense ratios, but most of them are the result of temporary fee waivers. Many have unacceptably high expense ratios. And an appalling one-third of index funds even charge sales loads or 12b-1 fees. Their sponsors ignore the fact that minimal cost accounts for virtually all of the index advantage. About two-thirds of the U.S. equity funds are targeted against the S&P 500 Index.

The indexing concept, however, is much broader than the S&P 500 Index fund. Even though the theory of indexing works most effectively against the total stock market, the all-market index fund (based on the Wilshire 5000 Equity Index) is only at the beginning of its acceptance. What is more, indexing also works well for investors who, for one reason or another, seek to earn higher returns in specific broad market sectors. Funds modeled on growth indexes and value indexes, as well as small-cap and mid-cap indexes, will also grow in acceptance. It is only a matter of time until someone has the good sense to offer index funds that match each of the nine Morningstar style/market-cap boxes. As shown in Chapter 6, index funds would have produced highly effective risk - adjusted returns in each box. Index funds are in the incipient stage in the international stock markets and in the bond market, too, but they will become far more important there in the years ahead.

Index funds are threatening to become the holy grail of mutual fund investing—the optimal way to approach the return of the markets—and deservedly so. During 1998, index funds claimed an estimated 25 percent of the net new cash flowing into equity funds, up from just 10 percent in 1990.

Assuming that investors continue to see the merit of indexing strategies as the best means to outpace the long-term returns of actively managed funds—a point that the past data abundantly demonstrate—how can sponsors of traditional funds compete? Material cuts in the fees they charge seem unlikely because their profits would be slashed. A reduction in portfolio transaction costs is also unlikely, for it would result in unacceptably radical changes in today’s silly, but chic, high-turnover investment policies. So what are they to do?

The Index Fund Elicits a New Industry Mantra

Fund sponsors must respond in some other way to the challenge of indexing. They must create a new holy grail, and that is the very path that much of the fund industry is following. The idea is to have investors actively manage their own fund portfolios, the better (or so the theory goes) to achieve returns that provide, not merely 99 percent of the market’s return, but well over 100 percent. The new strategy seems to entail ingredients like these:

• Don’t own a fund for the long term.

• Treat funds as stocks. Own lots of them and change them frequently.

• Exercise your freedom of choice—often.

• Dash to the nearest fund supermarket, and swap funds free of trading costs (or so it is incorrectly alleged).

• Heed the ads for those handsome past performers whose returns are advertised on your television screen.

• In all, the message seems to be “switch and get rich.”

This grotesque transfiguration of the long-term nature of fund investing is now well under way. Equity fund investors currently hold their shares of a given fund for an average of but three years.

But does it work for people to trade their mutual funds like stocks? Are there methods for selecting and swapping mutual funds that might result in superior returns? Are there strategies that have worked in the past? In this chapter, I’m going to examine that question from four vantage points: first, the theoretical world of academe, from which massive studies of fund performance have emanated; second, the real world of fund selection, reflected in the records of funds that have actually outpaced the market in the past; third, the records of advisers who recommend fund portfolios; and fourth, the records of funds that invest in other funds (funds of funds).

Selecting Winning Funds—An Academic Activity

Given the ability of computers to spit out endless performance comparisons, multiple regressions, and complex formulas, our academics have tested, well, everything. While a lot of data mining may well be involved in what is duly recorded on this subject in the Journal of Finance, the Journal of Portfolio Management, the Financial Analysts Journal, and similar publications, these respected and thoughtful scholars have no axe to grind. And they have carefully examined the record to determine whether there are past factors that may persist over time and thus may be valuable in selecting funds that will provide superior future returns.

The Sharpe Study

What have the academics found? We’ll start with the guru of the academic profession in the mutual fund arena, Professor William F. Sharpe of Stanford University. He carefully examined the 10-year records of the 100 largest equity funds (measured each year), accounting for more than 40 percent of the assets of all such funds. He then compared their returns with the returns of comparably weighted market-sector indexes, including a U.S. Treasury bill component (thereby accounting for the persistent performance lag created by fund cash positions).¹

Dr. Sharpe properly acknowledged that the cost advantage ascribable to large funds probably provided superior relative returns for his sample of funds, but found nonetheless that the average return of the funds he studied fell short of the multi-index return by 0.64 percent per year over the past decade. (It should go without saying that using the 100 largest funds in itself creates a substantial bias in favor of successful funds.) The shortfall could not be deemed significantly different from zero, but the data surely undermined any belief that a typical actively managed equity fund can outperform a passive alternative. (The data would have been even less favorable to the funds if Sharpe had included sales charges.)

Dr. Sharpe then singled out those fund managers who seemed to have demonstrated skill in selecting stocks over various interim periods, and examined whether the success continued in future periods. He investigated common measures for judging funds—size, past performance, and the Sharpe ratio of risk-adjusted return. The best evidence of some level of performance consistency appeared in the results for the previous 12 months (i.e., selecting a fund on the basis of its year-earlier performance slightly improved the chance of seeing that performance continue). An investor who had held the top 25 funds—the top quartile in Sharpe’s study—shifting funds as needed on that basis year after year, would have added an annual return of 0.8 percent relative to the index return over the subsequent five- and 10-year periods. (An investor who had holdings in the bottom quartile would have underperformed by 0.5 percent per year over the five-year period and 1.3 percent annually over the 10-year period). Even disregarding the extra taxes incurred by switching funds regularly, this rate of return would seem a rather shaky basis for an investment strategy.

Do winners repeat? Sharpe summarized his results this way: “If the past 10 years are indicative of the next 10, one might answer in the affirmative ” (although, I would note, the positive margin is modest to a fault). However, perhaps Sharpe’s neutral position (not proven) is more appropriate, for he conceded that “the evidence is far from conclusive, statistically or economically.”

The Carhart Study

Mark Carhart, of the University of Southern California, is another respected scholar who tackled the issue of persistence in fund performance. He evaluated 1,892 diversified equity funds over 16,109 fund years (amazing!) from 1962 to 1993.² First, he found that “common factors in stock returns [value vs. growth, large cap vs. small cap, high beta^t vs. low beta] and investment expenses almost completely explain persistence in equity fund returns.” Properly adjusting for the customary failure to consider the effect of the subaverage returns of funds that have gone out of existence, Carhart confirmed Professor Burton Malkiel’s conclusion, described in Chapter 5, that survivor bias has enhanced past annual returns reported for funds over the 1982-1991 decade by about 1.4 percent per year. Dr. Malkiel also found some limited evidence of persistence during the 1970s, but none during the 1980s.³

Looking at past one-year returns relative to those of the subsequent year, Carhart concluded, among other things, that relatively few funds stay in their initial decile ranking, although funds in the top and bottom deciles maintain their rankings more frequently than the 10 percent that mere chance would suggest. The 17 percent of funds repeating in decile 1 seems less than compelling. The 46 percent of funds repeating in decile 10, on the other hand, is quite imposing, a performance that seems largely explained by the fact that many low-decile funds tend to be trapped there by their high costs. In his conclusion, Carhart warns: “While the popular press will no doubt continue to glamorize the best-performing mutual fund managers, the mundane explanations of strategy and investment cost account for almost all of the important predictability of mutual fund returns.” Translation: Relying on past records to select funds that will provide superior performance in the future is a challenging task.

The Goetzmann-Ibbotson Study

In another study, William Goetzmann and Roger Ibbotson tested the repeat-winner hypothesis over two-year, one-year, and monthly intervals from 1975 to 1987.⁴ For all periods, they ranked equity mutual funds in terms of both raw returns and risk-adjusted returns, and then split them into two categories: winners (top 50 percent) and losers (bottom 50 percent). Their analysis indicated that investing in winners slightly increased the chance of outperforming the return of the all-fund average in the subsequent period, an important measure because funds that underperformed by reason of high expenses tended to repeat their shortfalls.

By way of example, their study of growth mutual funds over two-year periods revealed that past top performers had a 60 percent chance of being winners over the subsequent two years. Therefore, one might conclude that the chance of a fund’s being better than average in four subsequent two-year periods would have been about one in eight. Exceeding the average fund return in each succeeding two-year period, in short, was hardly an odds-on wager—and the odds would have been far worse if sales charges and taxes had been taken into account.

To make matters worse for those who advocate the merits of enhancing returns by moving from one fund to another, even relatively consistent winners might be losers relative to the market index. Goetzmann and Ibbotson explicitly conceded that picking winners—even when defined as funds in the top quartile, based on their performance relative to their peers—may not be enough to beat the market. They concluded: “While the ’ repeat-winner’ pattern may not be a guide to beating the market, it does appear to be a guide to beating the pack over the long term.” In the face of index fund competition, then, to what avail is a strategy that relies on evidence suggesting a tenuous persistence of a fund’s performance relative to its peers, when unaccompanied by any evidence—in fact, with considerable evidence to the contrary—of performance persistence that outpaces the market?

All of these academic labors in the statistical vineyards suggest that there is little, if any, persistence in performance. That is, the researchers have found no way to evaluate fund past returns and predict future winners with confidence. What is more, even if other studies, on other days, suggest that there is a secret—a new holy grail, as it were—such a record of past persistence itself would not necessarily be evidence that the same persistence would prevail in the future. The fact is that market conditions change; fund portfolio managers change (and rapidly, at that); fund organizations change; and fund strategies change, often influenced by the asset growth that success begets, as we will see in Chapter 12. This panoply of changes undermines the very relevance of the past, and effectively eliminates any link between past and future performance.

With that seemingly conclusive background from the theoretical world of academia, let’s now look at fund selection in the real world of investing. We’ll consider first, the actual records of the funds that did beat the market during the long bull market; next, the investment advisers who recommend mutual fund portfolios; and finally, the actual records of funds of funds, which invest solely in other mutual funds.

Funds That Have Beaten the Market—The Disappointing Reality

Despite the serious lag of mutual fund returns during the great bull market, one out of every six managed equity funds succeeded in outpacing the market’s return. Of the 258 general equity funds that survived that period (the industry was far smaller in 1982), 42 succeeded in outpacing the 18.9 percent return of the Wilshire 5000 Equity Index (a lower hurdle, to be sure, than the 19.8 percent return of the S&P 500 Index). But only 12 of those 42 (one of every 21 survivors) did so by a margin of 1.5 percentage points. If we assume that the funds’ annual tracking error, relative to the index, was a fairly modest 3 percent, then only a return of 1.5 percent in excess of the index return would represent statistically significant outperformance. Based on their actual tracking errors, only 3 of the 12 funds—only about one in each 100—cleared the hurdle of statistical significance. Nonetheless, it’s instructive to examine all 12 funds.

A Fund Manager Concedes

Literally no brute evidence exists to support the proposition that, out there somewhere, just waiting to be found, is a holy grail that will contain a message describing how to select, in advance, funds that will outpace the Standard & Poor’s 500 Index on the basis of past performance.

The mutual fund industry’s tacit acceptance of this reality has now become explicit for at least one fund adviser. In mid- 1998, Morgan Stanley Dean Witter, manager of some $160 billion of assets in load and no-load mutual funds, published a report entitled “Risk and Repeat Performance in Mutual Funds.” After examining the total returns of 660 equity funds during the two successive five-year periods comprising the 1987-1997 decade, the report concluded: “Of the funds in the best quartile of total return in the first period, only 28 percent remained in the top quartile in the second period, and 51 percent remained in the top half. Alarmingly, this figure is indistinguishable from ‘random’ results (which would put 50 percent in the top half ) . . . supporting a ‘null’ hypothesis in which there is no repetition of top performers” (italics added).

Despite the randomness of fund returns, however, fund risk profiles are quite persistent. Fully 63 percent of the funds with the highest volatility in the first period remained in the top quartile during the second period, 2½ times the random expectation of 25 percent. Similarly, 55 percent of the funds with the lowest volatility remained in the bottom quartile in the subsequent period, more than double what chance would suggest.

Combining random returns with persistent volatility, the report came to the obvious conclusion: Past risk-adjusted performance is more likely to be predictive than absolute performance alone. It then noted that “the S&P 500 ranked in the top quartile of risk-adjusted performance throughout the first and second periods.” Since “the bottom line is that risk-adjusted past performance is a superior predictor of future performance,” it follows that Morgan Stanley has concluded that the S&P 500 Index should continue to provide superior performance in the future. That this conclusion also strongly echoes my conclusion is not surprising. That the echo chamber from which it resounds lies in the corridors of a major mutual fund manager is astounding.

A bit of microanalysis shows that these 12 funds were a rather motley group. Six carved out their entire long-term margins in the early years, when their assets were small, and have been mediocre performers for years. That leaves six legitimate top performers. Interestingly, and importantly, all six had the same portfolio managers throughout most or all of the period (the managers’ average age is now 57); two closed to new cash flow before their assets reached $1 billion.

The 12 winners could not have been easy to identify in advance; at the outset, their shares were owned by relatively few fund investors. (Their aggregate 1982 assets totaled $1.8 billion, only 3 percent of total equity fund assets.) In any event, despite their acknowledged past success, no one can be sure of the extent to which it may recur in the future, whether or not their managers stay on the job or retire and rest on their laurels. Today, could investors be highly confident of superior returns if they selected one of the four legitimate fund champions that remain open to investors? It would seem, at best, a counterintuitive decision for an intelligent investor.

TEN YEARS LATER

Funds That Have Beaten the Market

When we update the returns of those 12 funds (out of 258!) that outpaced the all-market index by a significant margin in the 1982- 1998 period, two disappeared altogether (merged into other funds) and seven faltered (actually lagging the index during the subsequent period), leaving only three winning survivors. Among what I described as the “six legitimate top performers,” four lagged the market itself, with only two outpacing it. These are terrible odds! So much for the persistence of performance and of the predictive power of relying on the past as prologue to the future.

In the previous edition, I failed to mention another important issue: funds that fail and then die. While 258 equity funds survived that earlier period, 126 did not, a failure rate of an astonishing 32 percent. That failure rate has remained consistent in the past decade: An additional 77 of those funds have ceased to exist, 30 percent of the funds that began the period. This group is merely representative of what happens in the industry at large. Indeed, in 2008 alone, fully 399 funds were either liquidated or merged into another fund (usually in the same fund family, and usually one with a better record). How investors can invest for the long term in an industry in which the majority of funds endure only for the short term is an interesting question.

The Investment Advisers Who Select Funds—Another Disappointment

Next, let’s examine the public records of advisers who recommend mutual funds. For the past five years, the New York Times has published, each quarter, the records of equity fund portfolios selected and supervised by five respected advisers who began their task on July 7, 1993. During this period, not one of the portfolios has come close to matching the record of the Vanguard 500 Index Fund, which was chosen by the Times as the appropriate comparative standard. The advisers’ average annual return of 11.8 percent provided 59 percent of the annual return of the market, and the 500 Index fund provided 99 percent (see Figure 9.1). While some of these advisers chose equity portfolios that were designed to be somewhat less risky (i.e., less volatile) than the 500 Index itself, the decline in the Index during the third quarter of 1998 proved to be but 85 percent of the decline in the average fund portfolio of the advisers.

FIGURE 9.1 The Experts Speak: Five Advisers, $50,000 Investment

In any event, providing only 59 percent of the market’s annual return during a five-year period in which even the average fund provided 70 percent represents a failure that verges on the astounding. To make matters even worse, when it comes to the capital accumulated during the full period, the average portfolio of the advisers provided just 49 percent of the final growth of the S&P 500 Index, while the index fund provided 99 percent. Selecting winning funds, even by experts, is hardly bereft of challenges.

Another, longer-run evaluation of the success of advisers in selecting fund portfolios is the Hulbert Financial Digest. It reports that, of 59 advisory newsletters that it has tracked for a full decade, the average adviser’s portfolio has provided a return of 7.9 percent. This return represented 58 percent of the market’s return of 13.7 percent, as it happens, almost identical to the 59 percent figure achieved by the advisers whose returns have been reported by the New York Times study in a much shorter period. Only eight newsletters outpaced the market with their recommendations. Interestingly, and perhaps not surprisingly, that is very close to the one-in-six chance of superiority that the mutual funds themselves have displayed since mid-1982. For better or worse, during this bull- market era, many of these advisers recommended portfolios that were far more conservative than the stock market itself. On average, however, they carried a risk that closely approximated the risk of the market. With average risk but well-below-average return, their risk-adjusted return (measured by the Sharpe ratio) amounted to just 42 percent of the market’s risk-adjusted return, and only three advisers had higher risk- adjusted returns than the index. In all, the accumulated evidence regarding the ability of the experts to select winning funds remains not only negative, but far worse than what informed intuition might suggest.

TEN YEARS LATER

Investment Advisers Who Select Funds

The disastrous results turned in by the five investment advisers selected by the New York Times in July 1993 continued for about two more years. Then, in June 2000, despite the Times’s stated intention to run the adviser-versus-stock-market comparison for 20 years, the contest was discontinued after only seven years. We were never told why. Enough said.

Returns of Funds of Funds—Yet Another Disappointment

The third real-world test consists of the actual records of funds of funds—mutual funds that select other mutual funds for their portfolios. And these records are the most deplorable of the lot. The funds of funds not only lag the market—we now know that five of every six funds have done that—but they seriously lag even the style categories of the funds in which they invest, in part because of the extra layer of costs they almost universally add. For example, in the year ended June 30, 1998, of the 14 funds of funds investing in large-cap blend (value and growth) funds, four ranked in the 96th to 100th percentiles (one was dead last) and five ranked in the 90th to 95th percentiles. The champions, if that’s the right term, of this undistinguished group ranked in the 65th percentile, lagging two-thirds of the peer funds from which they made their selections. In all, the 93 funds of funds with full-year records achieved about what might have been expected from a random selection of funds that was reduced by an added layer of costs of more than 1 percent: an average of the 68th percentile compared to their regular fund-style peers.

I present the one-year results only because so few funds of funds have been around very long. Over the past decade, when only nine of them existed at the outset, the record was a bit worse: they lagged 69 percent of the funds in their peer groups. But excluding the single fund that did not add a layer of extra expenses (it outpaced 72 percent of its peers), the ranking quickly dropped down, with the remaining eight funds of funds achieving only a 75th percentile ranking among comparable regular funds. This neighborhood is hardly posh but is surely familiar, clearly reaffirming the one-year numbers presented earlier. To make matters even worse, managed funds of funds typically turn over their own fund portfolios at an average rate of about 80 percent per year, a short-term focus that inevitably impinges on the long-term returns they earn. The combination of high fund turnover and high fund costs, with two extra layers of cost—from high turnover and excessive operating expenses—has clearly proved to be a formula for failure.

Given the transitory nature of the one-year data and the existence of a limited number of funds over the past 10 years, perhaps the most relevant evidence is found in the three-year data. The past three years give us the opportunity to examine 35 funds of funds that have existed during the period, comparing each with its peer group: 11 large-cap, medium-cap, and small-cap stock funds; four international stock funds; 16 balanced (hybrid) funds, and four bond funds. The average fund of funds achieved a 66th percentile ranking, closely confirming the one- and 10-year findings. The average fund of funds returned an average of 15.5 percent for the period, a 2.4 percentage point shortfall to the average return of its peer group. Since more than half of this lag is created by the average expense ratio of 1.3 percent (1.7 percent excluding those funds that levy no additional fees) they added on, clearly the experts managing them had no particular selection ability sufficient to offset the costs of their services. Figure 9.2 shows the ranking of the 28 funds of funds among the 35-fund total that added on such fees in terms of their percentile rankings. It clearly reflects the powerful odds against successful fund selection for expensive funds of funds. It is a loser’s game.

FIGURE 9.2 Funds of Funds—Total Returns Relative to Peer Group (June 1995-June 1998*)

TEN YEARS LATER FIGURE 9.2 Funds of Funds—Total Returns Relative to Peer Group (June 1995-June 2009**)

To make matters worse, I believe it would be optimistic to expect that a 66th percentile rank can be sustained. Those funds of funds that bear an extra layer of fees have carried their own expense ratios averaging 1.7 percent (one-fourth incur expense ratios of 2 percent or more) piled onto the all-in costs of the underlying funds (averaging about 2 percent). Total annual costs borne by shareholders then reach to almost 4 percent. Such an extra deduction—assuming that their managers, on average, pick average funds—should produce about a 75th percentile rank. In any event, it would take naïveté to undreamed-of heights to believe that such a heavily loaded package of funds could ever outpace appropriate market indexes. Yet the funds -of-funds industry, as it were, is booming. Some 70 new such funds have been formed since June 1995, bringing the total to more than 120. But the record is bereft of evidence that the game is worth the candle.^u

A Caveat

Before leaving this subject, I want to emphasize a critical distinction among funds of funds: whether they add an extra layer of costs. As these costs are added, the odds against superior returns relative to regular mutual funds escalate. However, funds of funds that levy no extra costs (there are only a handful) do not carry this handicap. The record clearly supports this distinction. While funds of funds that bear extra costs have provided returns that have outpaced only 32 percent of comparable mutual funds over the past five years, funds of funds that do not bear extra costs have outpaced 79 percent of comparable funds.

It goes almost without saying that investors who consider owning funds of funds should look first at those that (1) do not add this extra layer of costs, (2) themselves focus on low-cost funds, and (3) carry no sales loads. There is no reason that such funds cannot provide competitive returns, or, as they have during the past five years, returns exceeding the norms of their peer funds.

“I Can Call Spirits from the Vasty Deep ...”

In Henry IV, part 1, Shakespeare tells us of Glendower’s bragging, “I can call spirits from the vasty deep.” To which Hotspur responds, “But will they come when you do call for them?” That is a good question to ask when appraising the past performance of mutual funds. Any professional analyst of fund performance—or any armchair investor, buttressed by Morningstar Mutual Funds—can summon from the quagmire the names of the best-performing mutual funds of the past—those that have outpaced their peers and representative market indexes. That is the easy part.

The tough part is having the future winners come when they are summoned now. Even if yesterday’s solid performers do appear, abundant statistical evidence suggests that they won’t repeat their superiority tomorrow. Yet, investors persist in believing that they can select, in advance, funds that will outperform the broad market indexes. That expectation is easy to understand. Some funds manage to outpace the indexes over substantial periods of time, offering seemingly incontrovertible proof of management superiority that will endure. But it rarely does. By the time a long-term record of superiority has emerged, the outstanding mutual funds with outstanding records may already be colliding with an immutable principle of the financial markets: reversion to the mean.

Discussed at length in the next chapter, mean reversion is a first principle of financial physics. Even the funds with the very best past records have a strong—and, in the long run, overpowering—tendency to gravitate to average gross returns, and, hence, below-average net returns. This tendency is rein forced by the fact that mutual funds with outstanding returns tend to attract large cash inflows from investors, and, as a result, are gradually stifled in their search for return superiority. The business of investment management—like the business of selecting portfolio managers—is fallible, tough, and demanding, particularly for mutual funds carrying the deadweight of excessive costs. Surely, summoning the spirits from the vasty deep—calling for the top performers to repeat their past success—is far easier than having them come and answer our call for continued excellence.

TEN YEARS LATER

Funds of Funds

It’s not especially significant in the grand scheme of things that Robert Markman lost his bet with me by a wide margin. (He graciously and promptly paid me the $25 that I won.) It is significant, however, that his fund empire has tumbled, with assets falling from $231 million in 1999 to $14 million today. In 2002, he closed one fund, and rolled the three others into a new one. The new fund struggled for a few years, and was ultimately closed in September 2009.

More broadly, the fund-of-funds concept isn’t looking so good. Most funds of funds continue to lag the returns of the funds comprising their peer groups. In the previous edition (when funds of funds, on average, lagged 66 percent of their peers), we had only three years of data available. Updating the records of those funds through mid -2009, only 17 of those original 28 funds remain, and the record of those survivors remains unimpressive, lagging 72 percent of their peers on average.

One might think that this record of disappointing returns by funds of funds would have put a sort of hex on the utility of the concept. But the reverse has happened; the number of funds of funds has burgeoned (to 833 currently), and they have become a major factor in the industry. Why? Largely because of the creation of so-called target-date funds, in which fund managers select (and manage) a collection of funds under their supervision and—as a broad generalization—offer them to investors as an asset allocation package designed for retirement in a specific year, reducing equities and increasing fixed income securities as the target retirement date approaches. The major fund managers typically set target dates for every five years from 2010 to 2050. Currently, among 833 funds of funds, fully 320 are target-date funds.

The recent bear market, however, has raised serious questions about the appropriate stock-bond ratio for target-date funds, especially for investors nearing retirement. My (admittedly rule-of-thumb) formula is to set the percentage in bonds to equal one’s age (i.e., at age 55 an investor might consider as a starting point a 55/45 percent bond/stock allocation). But target-date funds are typically much less risk-averse. The 2020 target funds, for instance, have invested from 60 percent to 80 percent of their portfolios in equities. During 2008 to mid- 2009, these 2020 funds have experienced declines of up to 37 percent in value. With only a decade-plus until retirement, investors are justifiably disappointed, for these losses will be hard to recoup. Funds-of-funds growth, accordingly, has slowed dramatically.

Of course the high-cost issue remains. (It never goes away!) While the largest target-date funds include only the costs of their underlying funds in their expense ratios, the range of those costs runs from 0.18 to 0.86 percent. Shockingly, how ever, more than half of target-date funds carry their own hefty expense ratios—which average 0.45 percent—in addition to the expense ratios of the underlying funds, usually in the range of 0.70 to 1.30 percent. Together these costs can reach almost two percentage points, paid year after year.

If you like the target-date idea, carefully consider the records of the underlying funds, the asset allocations to equities and bonds, and the all-in costs. Of course, I favor index funds as the underlying funds, the more risk-averse funds, and those with the lowest all-in costs. The message is clear: Caveat emptor.

No Holy Grail Here—Academic or Pragmatic

Whether we consider academic studies (many of which, I presume, included tests of predicting future returns that were found wanting and were never published), or the pragmatic and unforgiving actual results of the funds with the best long-term records, or the picks of fund advisory services, or records of funds of funds, the odds of selecting mutual funds that are top performers in the future have proved extremely poor. The chances that individual fund investors will find the holy grail that will identify in advance the future’s superior performers seem equally dismal.

Before this era of performance evaluation on a relative basis and sophisticated return attribution on a factor basis, equity mutual funds with active managers who achieved the best sustained long-term records represented the pinnacle of performance excellence. In recent years, the acceptance of such funds as representing the holy grail has been endangered by the clear performance superiority of the index fund, and by its rapidly increasing acceptance. As a result, much of the industry has, at least implicitly, mounted a counterattack. If only a rare fund can hope to go toe -to-toe with the market on a long-term basis, aggressive fund distributors seem to argue, let’s gain an edge by encouraging investors to abandon the conventional buy-and-hold fund strategy and switch opportunistically among funds. To be sure, the thesis leaves aside the self-evident fact that, although some investors may, against all odds, succeed in outpacing the market by astute selection of funds, investors as a group must underperform the market by the amount of their costs. This brute fact remains firmly in place.

In short, the traditional investor strategy of holding managed mutual funds for the long term has not provided the holy grail of market-superior returns—not by a long shot. Nor will the current fad of switching rapidly into and out of funds. The index strategy, by definition, must provide less-than-market returns—but only by a slight margin. And that is the true holy grail: achieving through a diversified investment portfolio a return that is as close to 100 percent of the market return as is possible. The odds remain high that few equity mutual fund portfolio managers will beat the stock market, and that, over the long pull, even those who win will not do so by a very wide margin.

After all, fund managers are mere mortals who operate in highly efficient markets. The bogus fund-switching strategy in vogue today, implicitly designed to counter the index strategy by misleading investors into thinking that, individually, they can somehow outfox the market, is certain (I choose that word carefully) to be a loser’s game. And the argument that a fund of funds can somehow emulate the result of a long-term buy-and-hold index fund strategy by adding a fee averaging 1.7 percent per year on top of the 2 percent cost incurred by the average fund flies in the face of reason. Abundant and compelling past evidence reinforces the validity of this elemental conclusion.

For fund managers, the most effective response to the challenge of the index fund is not a chimera—ever to chase the market return but never capture it—but common sense. Fund managers must reduce fees to equitable levels, return to the traditional fund philosophy of long-term investing, and limit the asset levels of the portfolios they manage to a size appropriate to their strategies and objectives. These changes should make the returns of actively managed funds more competitive with those of passive index funds. Taken together, each of these small steps toward manager competitiveness would constitute one giant forward step for the mutual fund shareholders. The golden rule—Put the investor first!—is the best route to the holy grail we should all be seeking. If this industry fails to implement this golden rule, low-cost index funds will continue to provide the last best chance for investors to find the holy grail of optimal investment returns.

TEN YEARS LATER

Selecting Superior Funds

The evidence powerfully confirms that, at least in the mutual fund industry, the holy grail doesn’t exist. But investors seem hell-bent on carrying out the search for the winning funds of the future, no matter how futile the search has proven to be. As I wrote in the 1999 edition, “index funds will continue to provide the last best chance for investors to [earn] . . . optimal investment returns.” The events of the past decade simply add additional weight to that conclusion.