For almost five decades, the literature on the investment performance of mutual funds has found that very few managers possess sufficient stock-picking or market-timing talent to allow them to consistently and reliably produce positive risk-adjusted performance after considering their fees. In other words, there’s little to no evidence of outperformance beyond the randomly expected.
As my co-author Andrew Berkin and I discuss in our book, “The Incredible Shrinking Alpha,” while perhaps disheartening, this result shouldn’t be surprising given the very high skill level of active managers competing fiercely in a zero-sum game, even before expenses. Thus, investors shouldn’t expect there to be many opportunities for a free lunch.
In addition, because we should expect the scarce resource to earn any “excess returns” that occur (and the ability to generate alpha is far more scarce than investment capital), it is naive to expect that mutual fund managers won’t charge sufficient fees or attract a sufficiently large amount of assets to effectively capture any alpha they generate. Said another way, investors should not expect to be the beneficiaries of the manager’s skill.
Despite the large body of evidence demonstrating that it’s a loser’s game (one that, while possible to win, has odds so poor that it’s not prudent to try), the most common strategy used by both institutional (such as pension plans and endowments) and individual investors to select a fund manager involves hiring outperforming managers and firing underperforming ones.
Buying The Winners
Bradford Cornell, Jason Hsu and David Nanigian contribute to the literature on this strategy with their February 2016 study, “The Harm in Selecting Funds That Have Recently Outperformed.”
The authors note that research on investor behavior has found that, in defiance of the evidence, fund flows “are positively correlated with past performance. Anecdotally, investment consultants and fiduciaries acknowledge that past outperformance is ‘a’ if not ‘the’ dominant manager selection criterion, because it is intuitive and thus defensible to investors.”
To test the strategy, Cornell, Hsu and Nanigian examined whether selecting managers based on recent performance leads to outperformance for investors. Given that three years is the typical investment horizon used by institutional investors in making hiring and firing decisions, they used that horizon in their study.
To simulate the impact of actual decision-making based on track record, they compared the performance of investment policies that involve investing in a “winner strategy” (an equal-weighted investment in the top decile of funds based on benchmark-adjusted returns) to results from a “median strategy” (an equal-weighted portfolio of funds ranked between the 45th and 55th%iles) and a “loser strategy” (an equal-weighted portfolio of the bottom decile of funds).
The authors note: “Funds in the ‘Winner Strategy’ bucket would generally be the funds that are selected by wealth management platforms as part of their buy or recommended list and recommended by financial advisors to clients for consideration. Funds in the ‘Loser Strategy’ bucket would generally be funds that are not on any recommended list and are actively being eliminated from client portfolios by financial advisors.”
They also examined the investment performance produced by the strategy of investing in funds that underperformed their benchmarks by more than 1% per year, and the even more extreme case of investing in funds that underperformed their benchmarks by more than 3% per year. They wondered if doing so would eliminate future bad performance from the portfolio (or, perversely, if it would lead to future outperformance due to mean reversion).