Accounting for numerous costs and biases points to an even greater defeat for active strategies
Active-management diehards who still believe in the promise of stock-picking will surely not be pleased with newly released findings from US-based Dimensional Fund Advisors.
In its latest 2019 Mutual Fund Landscape Report, the firm examined the track record of the universe of US-based mutual funds — including fixed-income, US equity, and international equity funds — as of December 31, 2018.
In an effort to arrive at a fair comparison, the authors first sought to account for survivorship bias: aside from considering the number of funds that have gone through 10-, 15-, and 20-year periods of continuous existence, the study counted how many of the “surviving” funds actually outperformed their benchmarks.
“More than half of the equity and fixed income funds were no longer available after 20 years,” the report said. “Including these non-surviving funds in the sample … suggests that only a low percentage of funds in the original sample were ‘winners’—defined as those that both survived and outperformed benchmarks.”
The report found that over the 20-year period ending on December 31, 2018, just 23% of equity funds and 8% of fixed-income funds actually survived and outperformed their benchmarks.
Another misconception that the report sought to demolish: “past performance predicts future results.” While investors may select mutual funds based on their past success, the report noted that outperformance may end up not being repeated. Driving home the point, it said only a minority of funds that fell within the top-quartile categories based on previous five-year returns (21% of equity funds and 28% of fixed-income funds)also ranked in the top-quartile of returns over the following five-year period.
“Some fund managers might be better than others, but track records alone may not provide enough insight to identify management skill,” the report said. “Stock and bond returns contain a lot of noise, and impressive track records may result from good luck.”
The report also examined the effect of costs on performance, suggesting the importance of asking “whether the costs are reasonable and indicative of the value added by a fund manager’s decisions.” Focusing on the explicit cost represented by expense ratios, the report confirmed that mutual funds with the highest expense ratios displayed the lowest rates of outperformance, with just 11% of the highest-cost active equity funds and 3% of the highest-cost active fixed-income founds outperforming their benchmarks.
Trading costs for equity funds, which include brokerage fees, bid-ask spreads, and price impact, can also play a sizeable role. Using portfolio turnover as a rough proxy for trading costs — the more turnover a fund registers, the higher the presumptive costs — the study found that only 15% of the highest-turnover equity funds outperformed over the 20-year period through 2018.
“Despite the evidence, many investors continue searching for winning mutual funds and look to past performance … [and] surrender performance to high fees, high turnover, and other costs of owning the mutual funds,” the report said. “In the end, investors should consider other aspects of a mutual fund, such as underlying market philosophy, robustness in portfolio design, and attention to total costs.”
