Blog - Investing Notes
January 22, 2007 - The Rareness and
Elusiveness of Mutual Fund Outperformance
What are an investor's chances of reaping abnormal returns from mutual
funds? Is it possible to identify the funds that will outperform? In
their December 2006 paper entitled "Mutual
Fund Performance", Keith Cuthbertson, Dirk Nitzsche and Niall O’Sullivan
address these questions via review of past academic research on US and
UK managed mutual funds, with focus on studies done within the last
20 years. They conclude that:
- On average, both index mutual funds (by roughly the total expense
ratio) and actively managed mutual funds underperform appropriate
benchmarks after fees. Only 2-5% of equity mutual funds show truly
skillful net outperformance. However, 20-40% of funds exhibit
clear (worse than bad luck) net underperformance.
- The drivers of relative performance among mutual funds are mostly
load fees and expenses and, to a lesser extent, portfolio
turnover. There is little evidence of successful market timing
by mutual funds.
- Mutual fund outperformance does persist, most noticeably for periods
of one year or less. However, economic gains to investors who actively
rebalance into winner funds may be marginal because of transactions
costs and fund fees. Sophisticated (such as Bayesian)
sorting rules may enable substantial gains from rebalancing into winners
monthly.
- Past loser funds clearly tend to continue underperforming for several
years.
- Results for bond mutual funds are generally similar to those for
equity mutual funds.
- Hedge funds show better risk-adjusted performance than do mutual
funds, and stronger persistence of outperformance.
- Overall, results suggest that the typical investor should hold
low-cost index funds and especially avoid actively managed
funds with poor past performance. Only very sophisticated investors
should consider an active mutual fund switching strategy.
In introductory sections, this paper provides an overview of mutual
fund industry structure and performance measurement in the US and UK.
In summary, this review of mutual fund studies makes low-cost, broad
market exchange traded funds sound good.
For related research, see Blog
Synthesis: Mutual Funds and Hedge Funds.
