In my blog last week, I noted the lack of evidence of investment skill demonstrated by fund managers. This issue always elicits a passionate response, with readers providing their favorite examples of managers who outperformed the markets. These examples miss the point. I am not suggesting no one can beat the markets in any given year, or even over longer periods of time. The evidence indicates that, when they do, it can usually be explained by luck, and not skill. Many studies illustrate this fact, but few investors understand them or appreciate their significance.
Brokers and the financial media are quick to anoint new fund gurus. They do so based on past performance, which is no indication of future results. When the fund manager underperforms, they recommend getting rid of him and repeating a process which has already been discredited. Retirement plans have investment committees that spend hundreds of hours engaged in this useless exercise.
The biggest problem with this ritual is that a short track record is not indicative of skill. It takes many years of data for outperformance by a fund manager to have statistical significance. Excel users with basic skills can determine the "alpha" of a fund manager, which is the average of the differences between their returns and a risk-appropriate benchmark return over the years. Then use the standard deviation formula to calculate how irregular the alpha has been. Those two numbers entered in this calculator will allow you to determine how many years of a track record are necessary in order to attribute the outperformance to luck or skill. A typical manager, with a good track record, might have an alpha of 2 percent and a standard deviation of 6 percent, which would require 36 years of data before you could safely conclude he had legitimate investment skill. By this time, he would have extracted high fees for many years and been retired to his villa in the South of France.
There are thousands of mutual funds. In any sampling this size, a small number of fund managers will yield results indicative of skill, but their alpha is most likely attributable to luck. The odds of identifying skillful managers in advance are extremely small.
Even if you were fortunate enough to locate this needle in the mutual fund haystack, how confident can you be that his stellar performance will persist? Studies of mutual fund performance demonstrate little persistence by those anointed as investment stars based on their past performance. Burton Malkiel noted, in his seminal book, A Random Walk Down Wall Street, "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."
The next time your broker tells you to buy a mutual fund he is recommending, ask him these questions:
1. Why are you able to identify just a couple of managers who you believe have genuine investment skill out of the thousands out there?
2. If you are basing your recommendation on their past performance, doesn't the SEC require disclosure that past performance is no guarantee of future results?
3. Did any of your clients actually capture the returns you are touting?
4. How many years of data did you look at before you concluded the fund manager has genuine investment skill?
The answers to these questions will quickly expose the folly of the exercise of trying to identify in advance fund managers with legitimate investment skill.
As noted by Nobel Laureate Paul Samuelson, in Challenge to Judgment, 1974, dismissing those who believe they can find managers with this skill: "They always claim that they know a man, a bank, or a fund that does do better. Alas, anecdotes are not science. And once Wharton School dissertations seek to quantify the performers, these have a tendency to evaporate into thin air--or, at least, into statistically insignificant t-statistics."
Dan Solin is a Senior Vice-President of Index Funds Advisors (ifa.com). He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.