Flawed Advice for Picking Mutual Fund ‘Winners’

The markets are efficient to the extent that stock picking, market timing and track record investing do not work. The only evidence that can be used is to own equities, globally diversify and rebalance. Combine this with discipline and a successful financial future can be yours.

Common Sense on Mutual Funds: New Imperatives ...
Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor (Photo credit: Wikipedia)

If there was a way to identify “topnotch” actively managed funds that were likely to outperform their benchmarks, investors should include only those funds in their portfolios. Regrettably, I am aware of no data indicating anyone has the expertise to make this determination. Looking at past performance is not helpful. One studylooked at the performance of the top 100 mutual funds over a thirteen year period from January 1, 1998 until December 31, 2011. It found that about 15 percent of the top managers from one year periods repeated their top 100 performance in the second year.What about Mr. Zimmerman’s advice to consider outperformance over a ten year period? Using Morningstar Direct, I did a search for current active fund managers with 13 years or more of experience. The dates used were July 1, 1999 through June 30, 2012. I then eliminated all managers who did not beat their benchmark by 2 percent or more during the first 10 years of this period (July 1, 1999-June 30, 2009), which left 340 funds in my database. My goal was to determine how investors would have done in the past three years if they had followed Mr. Zimmerman’s advice and selected “topnotch” funds that had outperformed their benchmarks in the prior ten year time period. Here’s what I found:

Mr. Zimmerman is correct that lower expense ratios have an impact on returns. Funds with expense ratios less than 1 percent for the prior 10 year period had an average “alpha” of 4.64 percent. Very impressive. I can understand why investors would believe these fund managers had figured out how to beat the markets. They would have been very disappointed. In the ensuing three year period, these same funds on average underperformed their benchmarks by 0.53 percent.

The data was worse for active funds with an average expense ratio greater than 1 percent. The average outperformance of these funds was 5.17 percent for the ten year period. In the following three years, average underperformance was 1.19 percent.

Seeking actively managed mutual funds based on past performance will only disappoint the investor. There has been no method to consistently predict which active fund manager will repeat their stellar performance. To success, long term, we must own equities…globally diversify….rebalance.

Please comment or call to discuss how this affects you and your financial future.

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