Mutual Funds

Companies | Education | Do Past Winners Repeat?

Gary Karz, CFA (email)
Host of InvestorHome
Principal, Proficient Investment Management, LLC

Mutual Fund Companies

• US Mutual Fund Families
• The Vanguard Group
• Fidelity Investments

Guides and Periodicals

• The vast majority of money invested in mutual funds goes into funds that have either four or five star ratings from Morningstar, which is the leading provider of mutual fund information. While its difficult to gauge the exact degree of causation (or correlation) between Morningstar ratings and fund purchases, it is clear that Morningstar ratings have an impact on investor behavior. As a result, Morningstar's rating system have been greatly debated. Morningstar has run many articles pointing out that hot fund categories tend to underperform unpopular categories. You can read about their Methodology here. Their ratings were the subject of numerous articles in the past. Wharton Professor Marshall Blume's article titled An Anatomy of Morningstar Ratings in the March/April 1998 issue of the Financial Analysts Journal argued that (1) funds with a long history are less likely to receive a five star rating than funds with a short history and that (2) no-load, diversified, domestic equity funds are far more likely to get four or five stars than they are to get one or two stars. Then in the July/August edition, Stanford Professor William Sharpe's article titled Morningstar's Risk-Adjusted Ratings" discussed drawbacks of Morningstar's system (another version). Mark Hulbert also noted top-ranked no-load equity funds tended to underperform in No Stars for Morningstar in Forbes (12/29/97).
• The EDGAR Mutual Funds database and Mutual Fund Cost Calculator from the SEC
• Mutual Fund Observer.

Education - See also Benchmarks and Performance Evaluation

• An introduction to Mutual Funds from the SEC.
• The Vanguard Group's Nothing Fails Like Success and The Implications of Style Analysis on Mutual Fund Performance Evaluation (which shows that fund expenses are an indicator of future performance) from John Bogle
• Of Tournaments and Temptation in the March 1996 issue of the Journal of Finance was an article that discussed mutual fund fees and how fund managers act depending on their performance.
• The July/August 1997 issue of Bloomberg Personal included an article titled "Cheaper is Better" by Jonathon Burton. The following are a few excerpts from the article
  • "Fund expenses make a difference-a huge difference-in your bottom-line investment return. In fact, according to a new study by Bloomberg Personal, low-cost funds are much more likely to deliver above-average performance than high-cost ones..."
  • "Phillips [Morningstar] has also produced disturbing research showing that higher-expense bond funds often take greater risks."
• What do individual investors consider when buying a fund? According to an (older) Investment Company Institute study 75% considered performance, 69% Risk, 49% Investment Goals, 46% Portfolio securities, and only 43% considered fees and expenses. Empirical studies suggest performance should certainly not be the primary consideration, but fees and expenses arguably should be.

Do Past Winners Repeat?

An important issue that has been the subject of intense debate is the question of whether mutual fund managers and funds that have performed well in the past will continue to outperform in the future. Mutual fund tracking services, periodicals, and web sites regularly publish top performing funds on a continuing basis. However, if past performance does not predict future performance, this information is of little use in selecting mutual funds going forward. While there have been studies showing that strong performers continue to outperform over certain periods, many studies have demonstrated that investors should not expect recent strong performers to outperform in the future. Does Historical Performance Predict Future Performance? by Ronald N. Kahn and Andrew Rudd (of BARRA at the time - 1995) is an example supporting the argument against persistent performance. The study includes references to previous studies that did and studies that did not find support for persistence. Although they did find some evidence of persistence in fixed income funds, the authors came to the conclusion that both equity and fixed income investors may be better served by investing in index funds as opposed to funds that have performed well in the past.

Another study by Burton G. Malkiel (author of A Random Walk Down Wall Street ) in the June 1995 edition of Journal of Finance titled Returns from Investing in Equity Mutual Funds 1971 to 1991 also addressed the issue. Numerous studies had demonstrated persistence in performance in the 1970s and Malkiel confirmed these findings. Malkiel specifically examined the issue of survivorship bias - the fact that poor performing mutual funds tend to disappear (commonly by merging into more successful funds "thereby burying the fund's bad record with it." Approximately 3% of mutual funds disappear every year (for that period). The result is that most long term performance records do not include the records of poor performing funds that no longer exist. By examining all mutual funds that existed at the time, Malkiel determined "that survivorship bias is considerable more important than previous studies have suggested." Malkiel admits that the analysis provided some support for the buying funds with excellent records since they outperformed during certain periods and do no worse than the average fund, however he presented three caveats. First, the results are not robust, second, the returns are not actually achievable because of load charges and third, survivorship bias has to be accounted for. He concluded that

• "It does not appear that one can fashion a dependable strategy of generating excess returns based on a belief that long-run mutual fund returns are persistent."
• "... funds have underperformed benchmark portfolios both after management fees and even gross of expenses."
• "... while considerable performance persistence existed during the 1970s, there was no consistency in fund returns during the 1980s."
• "... we have been unable to fashion a dependable strategy by which an investor can consistently achieve excess returns over long periods of time."
• "Most investors would be considerably better off by purchasing a low expense index fund, than by trying to select an active fund manager who appears to possess a "hot hand."

Malkiel also discussed Forbes Magazine "honor roll" which ranks mutual funds for performance in both up and down markets. Over the 16-year period from 1975 to 1991, the "honor role" underperformed the S&P 500. Further, the results ignored load charges which would have reduced performance. Malkiel also analyzed mutual fund fees to determine whether higher fees resulted in better performance. The study found "essentially no relationship between gross investment returns and expenses." Malkiel concluded that "The data do not give one much confidence that investors get their money's worth from investment advisory expenditures."

Mark M. Carhart (formerly at the University of Southern California and later Goldman Sachs) did extensive research on survivorship bias and authored On Persistence in Mutual Fund Performance in the March 1997 issue of the Journal of Finance. Carhart concluded that "The results do not support the existence of skilled or informed mutual fund portfolio managers."

Other articles on the subject include Performance Persistence by Stephen J. Brown and William N. Goetzmann in the Journal of Finance (June 95), The Grand Infatuation (7/99) by William Bernstein, and Past Performance via EF Moody.

In Bloomberg Personal, Roger G. Ibbotson wrote that "styles of mutual funds typically explain more than 90 percent of the variations in returns." Ibbotson argued that when comparing returns of funds to their benchmarks (as opposed to broad based benchmarks), winners do tend to persist. Ibbotson believes that it is not possible to forecast which styles will do the best, but predicting the best funds within an investment style is possible. However, Ajay Khorana and Edward Nelling found little evidence of performance persistence by sector-fund managers relative to both their peer group and the S&P 500 (The Performance, Risk, and Diversification of Sector Funds in the Financial Analysts Journal May/June 1997)

More recently in The Right Answer to the Wrong Question: Identifying Superior Active Portfolio Management W. V. Harlow, and Keith C. Brown argue that while "identifying truly skillful portfolio management is hardly an exact science, investors can improve their chances greatly by recognizing that a fund’s past risk-adjusted performance is more likely than not to repeat itself in the future.

Eugene Fama and Ken French have Luck versus Skill in the Cross Section of Mutual Fund Returns forthcoming in the Journal of Finance (or here via SSRN). Their results imply that high costs translate into lower returns and few funds have returns strong enough to justify the costs. They further the argument that it is very difficult to differentiate luck from skill in evaluting managers. Fama and French also point out a weakness in persistence tests - since they are based on short-term performance results are potentially clouded by noise.

Regarding hedge funds, Professors Stephen J. Brown, William Goetzmann, and Roger G. Ibbotson (in their study Offshore Hedge Funds: Survival & Performance 1989 - 1995) found "no evidence of performance persistence in raw returns or risk-adjusted returns, even when we break funds down according to their returns-based style classification." They conclude that "the hedge fund arena provides no evidence that past performance forecasts future performance." It's important to note however, that this study covers a relatively short time period and that determining accurate and comparable performance figures in the hedge fund arena is extremely complex. There have been a number of more recent papers discussing performance persistence in Hedge funds including Survival, Look-Ahead Bias, and Persistence in Hedge Fund Performance (2005) and Hedge Fund Attrition, Survivorship Bias, and Performance (2010). More research from Professor Malkiel and others can be found on the Cherry-Picking page.

Unlike mutual and hedge funds, there is significant evidence or performance persistence in venture capital and LBO funds. See Private Equity Performance: Returns, Persistence and Capital Flows Journal of Finance (August 2005) by Steven N. Kaplan and Antoinette Schoar (Prior Versions).

Selected Quotes on Mutual Funds

"Todays hero is often tomorrows blockhead."
Peter L. Bernstein, Against the Gods

"There is some evidence that last year's winners tend to repeat next year. But it is very slight. Mostly the effect comes from the fact that really bad funds stay bad. Their expenses are high, and their choices stay haphazard."

Paul A. Samuelson, "The Long-Term Case for Equities," The Journal of Portfolio Management, Fall 1994.

How quickly investors flock to better-performing mutual funds, even though financial researchers have shown that the "hot" funds in one time period very often turn out to be the poorest performers in another.
David Dreman, The New Contrarian Investment Strategy

"If you pay the executives at Sarah Lee more, it doesn't make the cheesecake less good. But with mutual funds, it comes directly out of the batter."

Don Phillips (Morningstar President) in U.S. News & World Report article on July 8, 1996 commenting on whether paying higher fees for mutual funds results in higher returns.

"Past performance is no indicator of future results. Fund historical performance does not promise the same results in the future."
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