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The Rareness and Elusiveness of Mutual Fund Outperformance

| | Posted in: Mutual/Hedge Funds

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.

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