If investment mutual fund managers were truly skilled at beating the market, then you would expect mutual fund manager performance prowess to persist over time.
Unfortunately, the evidence indicates that superior past professional performance among mutual fund managers tends not to persist. Past superior mutual fund performance is simply not a predictor of future superior mutual fund performance.
Over time, securities prices change, because risk and return expectations change. Older concerns are resolved and new risks arise. As time and events roll forward, new information becomes available, that influences whether investors find a particular security to be more or less attractive. A vast array of financial, competitive, managerial, political, natural, technological, and numerous other factors will influence the evolution of securities market values.
Securities market prices are risk adjusted or risk weighted forecasts of unknowable future events.
Just because the price of an investment security changes over time does not mean that investors were right or wrong before when they purchased or sold short a security. It simply means that the future did not unfold according to the projected risk-adjusted market consensus that existed when the security was acquired. (See: Distinguishing between true investment skill and luck)
Securities prices are bound to change and there will be supposed “winners” and “losers.” Winners will take credit and boast of their supposed wisdom, while losers will tend to keep quiet and lick their wounds. The problem is that rarely do either winners or losers actually win or lose because they made a precise and accurate prediction of future events that actually did occur. (See: Chance creates the illusion that investors can beat the stock market)
When the investment portfolio performance of money managers is measured on a risk-adjusted basis, winners are judged to have captured “positive ‘alpha’ ” (a statistical performance comparison to a benchmark) and losers will have “negative ‘alpha.’ ” Are these positive and negative deviations from the average the result of skill, or are they just due to random price fluctuations?
If mutual fund managers were truly skilled at beating the market, then one would expect their excess investment returns performance to persist over time.
Most individual investors have long-term financial objectives and hope that money managers who are entrusted with their assets will deliver relatively high future performance. Unfortunately, the scientific finance literature does not support this expectation. The evidence indicates that superior past professional performance tends not to persist and is not a predictor of future performance. The most reasonable conclusion to reach is that relatively competitive and efficient financial markets are not reliably “beatable” on a long run, risk-adjusted basis.
The absurdity of the “positive alpha, superior mutual fund manager” assertion increases with the fees charged and the excess taxation resulting from over-active professional portfolio management. From the point-of-view of the individual investor, affordable alpha simply does not exist. Before costs and taxation, on average an investor can only expect to match the market return. Some will exceed the market return and some will fall short. However, it will tend to be luck rather than skill that will determine who wins and who loses. Once costs and taxation are factored in, the average investor will under-perform the market index.
The effort to find those few supposedly superior money managers willing to sell their services sufficiently cheaply is a costly, time consuming, and futile, “Where’s Waldo?,”* searching exercise for the individual investor.
Many money managers will claim to be superior and few or none actually will be. If such superior money managers did exist, then there should be dozens or hundreds of them who prove their superiority year after year after year. Unfortunately, the scientific finance literature indicates that this is not the case. This year’s star money manager tends to be next year’s average or laggard money manager.
Individual investors need to understand that proper evaluation of the potential skill of investment managers is not a trivial exercise. Institutions with assets to invest must select and monitor investment managers. They have fiduciary obligations to hire the best and the brightest of portfolio managers, who will in turn select and manage the actual investment portfolio. The scientific finance literature on investment manager selection is very extensive, goes back roughly four decades, and provides no easy, surefire answers.
For the individual investor, using something like a 4 star or 5 star rating to over-simplify the fund selection decision is no different than tossing darts to decide. (For some ideas on how individual investors might approach the investment fund selection decision more efficiently, see this category of articles on The Skilled Investor website: Selecting Investment Funds – Mutual Funds and ETFs. Also, see the articles in this category: Rating Services – Morningstar. )
* “Where’s Waldo” by Martin Handford is a series of illustrated children’s books. The objective is to locate Waldo wearing his little red cap within drawings that contain many many hundreds of other people. Finding Waldo is often challenging and time consuming. As opposed to searching for superior mutual fund managers, you actually can find Waldo with enough time.