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. )
Tags: mutual fund manager
Personal Financial Planning
- The Fund Authority Score – A Better Mutual Fund and ETF Rating System (Fund Authority Scores rate mutual funds and ETFs on the most important economic factors influencing long term diversified investment fund performance
The Skilled Investor developed the Fund Authority Score system to provide individual investors with concise and objective mutual fund and ETF comparisons within investment asset classes.
Fund Authority Scores measure investment fund cost, maturity, efficiency, and [...])
- Can you really beat the stock market? (
You are not likely to beat the stock market, despite all the cheer leading from the securities industry and the financial media.
When you try to beat the public securities markets, unfortunately you are more likely to trail the market’s return, because of extra costs, taxes, and investment mistakes.
The idea that investors can beat the market [...])
- How Many Mutual Funds are Needed for a Well-Diversified Portfolio? – Evidence (Actively-managed mutual funds are not created equally. Performance can vary significantly - even when funds pursue similar strategies or "styles."
This article addresses the impact on portfolio diversification of holding more than one actively-managed mutual fund. (For the companion article to this, see: How many mutual funds are needed for a well-diversified portfolio? – a commentary)
- Efficient Market Pricing in the Investment Securities Markets (
Efficient market pricing is the theory that all known information is already reflected in current securities prices.
Efficient securities market pricing has become very widely accepted within the investment community. The preponderance of evidence is that securities markets are efficient and tend to reflect available information. Whether you believe markets are efficient is very important to [...])
- Your Investment Risk Tolerance Drives Your Asset Allocation Decision (
Your personal tolerance for investment risk should drive your asset allocation decision - A Tip from The Skilled Investor
Your tolerance for investment risk is a relative thing. Few people like investment risk, but some can handle it better than others do. The more investment risk you can and are willing to tolerate, the higher your [...])
- How Investment Securities Are Valued – Snapshots in Time (
Snapshots in time - How investment securities are valued
Every securities market transaction requires a buyer and seller with differing viewpoints.
Markets can operate, because there are differences between investors in their assessments of the intrinsic value and risk of securities.
Current investment values vary in the eyes of the many beholders of investment market securities. Knowledgeable participants [...])
- How unstable have stock market returns been over time? (Common stock equity market returns have varied widely in the past. The common stock equity risk premium has averaged about 4.1% from 1872 to 2000.
The equity risk premium is the equity market return less the risk free rate of return. The risk free rate of return includes both the inflation rate and the risk free [...])
- Pay Lower Expenses To Get Higher Investment Returns – Part 2 (
Pay lower investment expenses to get higher investment returns
While financial services industry sales people tell you that you need to pay more to get more, the correct answer is the opposite.
Excessive investment costs are a plague on your personal financial planning. Excessive investment expenses are one of the most significant barriers to lifelong family financial [...])
- Build Investment Asset Buffers to Protect Yourself from Market Volatility (
Build Investment Asset Buffers to Protect Yourself from Market Volatility
You may be just as nervous as the next person is about investment risk. However, the coverage of your future expenses by your accumulated assets will determine whether you can actually manage, when risk really happens.
A previous article, "The Solution - ONLY follow financial strategies that [...])
- Diversify To Avoid Investment Fraud (Another kind of investment diversification that individual investors should consider important relates to the failure or corruption of the financial industry intermediaries and fiduciaries that hold individual investors’ securities.
This meaning of diversification has nothing to do with scientific investment principles related to optimal portfolio diversification. However, it is still very important. Prudent investment practices would [...])
- Stay Invested in Securities Markets to Earn Risk Premiums (You must stay invested in the securities markets to earn market return risk premiums
Securities markets pay risk premiums to risk takers
You have to have your money invested and at risk to be paid a risk premium. Attempting to avoid risk or losses by jumping in and out to "time the markets" does not work. Scientific [...])
- Understand the Confusing Securities Market Motion Picture (
Securities markets are usually very quick to adjust prices to reflect new information. However, this price adjustment process may take longer and be more volatile, if the new information is ambiguous.
At any point in time, market participants will already have used more or less rigorous valuation methods to judge their expected risk-adjusted value of securities. [...])
- Chance creates the illusion that individual investors can beat the stock market (
"Market efficiency" makes it very difficult for individual investors to "beat the market."
Making their own decisions, individual investors perform so poorly that on average their investment returns lag behind the returns that one would expect from random stock selection.
The average professional trader does somewhat better than amateurs do, and professionals probably do so, in part, [...])
- Use Scientifically Based Financial Planning Strategies (VeriPlan is designed to help you pursue scientifically based financial planning strategies
VeriPlan offers you unprecedented direct control to perform your own automated personal financial planning. VeriPlan's functionality also implements the principles of scientific finance. VeriPlan's internal documentation and its links to information on the web help you to understand scientifically based personal financial planning and [...])
- Avoid High Turnover Mutual Funds and Active ETF Trading (Avoid investment funds with higher investment portfolio turnover
The problem with high turnover is that higher fund trading adds substantial hidden expenses that drag down returns.
Because short-term trading is a zero sum game (before costs) played against other well informed traders, greater turnover is far more likely on average to result in lower fund returns instead [...])