Morningstar's Fund Manager of the Year: A Slippery Slope

I previously cautioned investors about the perils of relying on various lists of "best fund managers." One of the most popular of these lists is issued annually by Morningstar, which annually designates a "Fund Manager of the Year" in various categories.

Lipper, another well-known mutual fund researcher, also bestows awards on funds "that have excelled in delivering consistently strong risk-adjusted performance, relative to peers."

Presumably, investors rely on these awards as a basis for selecting mutual funds in their portfolios. This is unfortunate.

My colleagues at Index Funds Advisors studied the performance of sixteen domestic equity funds that received the "fund manager of the year" designation by Morningstar. It looked at data from the inception date of the fund manager (or, in two cases, from the inception date of Morningstar's benchmark) through 2011. Here's a summary of the findings:

Past Performance is no... (You know the rest)

Will Danoff, who managed the Fidelity Contrafund, was Domestic Equity Manager of the Year in 2007. In that year, he beat his benchmark by almost eight percent. In 2009, he underperformed his benchmark by almost the same percentage.

Mason Hawkins, who managed Longleaf Partners, won the award in 2006, when he beat his benchmark by 6.17 percent. He underperformed his benchmark by 6.22 percent in 2007 and by 13 percent in 2008.

Every one of the fund managers of the year had subsequent years of some underperformance. Perhaps the worst example is Jim Callinan, the manager of the RS Small Cap Growth fund, who was the 1999 Domestic Equity Manager of the Year. No wonder. His fund beat its benchmark by an unbelievable 140 percent! Then Jim fell off the wagon. In six of the seven ensuing years, he underperformed his benchmark. In the only year he beat it (2004), it was by a measly 0.85 percent.

The Lack of Evidence of Skill

Of the sixteen funds studied, only one fund manager evidenced skill based on a statistical test (the t-test) which determines if the fund's outperformance was really attributable to skill (with a 95 percent or higher probability) or if it could be explained by luck. Even if you can find a fund manager who passes the test for a finite period of time, it is not a slam dunk that his skill will persist in the future.

Helpful Data from Morningstar

While Morningstar's "Fund Manager of the Year" awards are likely to mislead investors, other data it provides is worthy of serious consideration. It reported 2011 inflows of passively managed long-term funds of $76.4 billion in 2011. In sharp contrast, actively managed funds had net outflows of $9.4 billion. Clearly, investors are getting the message. Still, the overall market share of actively managed funds, as reported by Morningstar, is 85.2 percent compared to 14.8 percent.

You want to be part of 14.8 percent. I call those investors the educated minority.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published December 27, 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.