Today I was reminded of a research paper by a couple of my favorite academics that helps validate the intellectual foundation of our investment philosophy at Frontier. The study is called “Luck versus Skill in the Cross Section of Mutual Fund Returns” and is a working paper by two giants in the area of market efficiency, Eugene Fama (University of Chicago) and Kenneth French (Dartmouth). They look at mutual fund performance since 1983 (when monthly returns began being recorded consistently), after costs and after controlling for a variety of data biases, and compare the actively managed funds to the broad market to see if there is any excess return among the actively managed funds that was strong enough and persistent enough to be the result of actual skill on the part of the manager(s). Active management, for those unfamiliar with the term, is when portfolio managers pick stocks they expect to outperform a broader market. Conversely, passive management is when you simply buy the entire market and accept the returns it yields.
They conclude in the study that there is evidence that skilled active managers exist, but only in the top three percent of the actively managed fund universe! That, of course, means that there are a lot of fund managers out there who are patting themselves on the back for their “market beating” performance when they deserve no credit whatsoever. In fact, they could actually be lousy portfolio managers who simply got lucky, just as many underperforming managers could actually be good but unlucky. The bottom line is that picking active managers becomes nothing more than a guessing game that one is more likely to lose than win after costs are factored in.
And, these conclusions offer us a new way to look at studies like the semiannual Standard & Poor’s Indices vs. Active (SPIVA) Funds Scorecard. While the SPIVA study does tend to show that a majority of active managers underperform their passive benchmarks over 1, 3, and 5 year periods, it also indicates that many active managers do outperform their index, even if a minority. While that may be the case during a given period, the Fama/French paper tells us that it is very likely that most of those outperforming funds were just plain lucky, giving an investor little confidence that an outperforming manager will repeat in the next period.
These kinds of conclusions become very disturbing when you consider what one pays active managers and those selecting active managers on their behalf. Actively managed U.S. equity funds charge, on average, 1.32%, and those investment advisors who build portfolios from actively managed funds often charge another 1% on top of that for their “efforts”. Pay 2.32% of assets just so your performance can depend on luck?! A much more rational approach, in our opinion, is to remove the luck component from this all-too-important endeavor and build portfolios with indexed vehicles using what we know about the various investable markets and their relationships to each other. That way, investors can get extremely efficient exposure to the markets at the level of risk appropriate for them, and at a much more agreeable cost since you aren’t paying for “luck” (some passive strategies cost as little as 0.07%), let alone all the other stuff that fees go toward at most firms. This approach is no walk in the park, of course, requiring time, effort, and a good dose of knowledge and perspective. But it yields a much more satisfying investment experience, we believe.
For those interested I’ve attached the Fama/French paper, Luck vs. Skill in Mutual Fund Investing, and the most recent SPIVA report to this email. Keep in mind, Fama/French paper is over 40 pages and very academic, but some of you may need help getting to sleep some night. The paper is also available in the Research section of our website in case anyone wants to find it again later.