Do Security Analysts Pick Winners? The Performance of the Mutual Funds
I can almost hear the chorus in the background as I write these words. It goes something like this: The real test of the analyst lies in the performance of the stocks he recommends. Maybe Sloppy Louie, the copper analyst, did mess up his earnings forecast with a misplaced decimal point; but if the stocks he recommended made money for his clients, his lack of attention to detail can surely be forgiven. “Analyze investment performance,” the chorus is saying, “not earnings forecasts.”
Fortunately, the records of one group of professionals – the mutual funds – are publicly available. Better still for my argument, any of the men and women at the funds are the best and highest-paid analysts and portfolio managers in the business, they stand at the pinnacle of the investment profession.
They allegedly are the first to learn and act on any new fundamental information that becomes available. By their own admission they can clearly make above-average returns. As one investment manager recently put it: “It will take many years before the general level of competence rises enough to overshadow the starling advantage of today’s aggressive investment manager.” “Adam Smith” echoes a similar statement:
All the players in the Game are getting rapidly more professional… The true professionals in the Game – the professional portfolio managers – grow more skilled all the time. They are human and they make mistakes, but if you have your money managed by a truly alert mutual fund or even by one of the better banks, you will have a better job done for you than probably at any time in the past.
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| Security analysts pick winners, isn't it so? Photo by Elena |
Statements like these were just too tempting to the lofty-minded in the academic world. Given the wealth of available data, the time available to conduct such research, and the overwhelming desire to prove academic superiority in such matters, it was only natural that academia would zero in on mutual-fund performance.
Again the evidence from several studies, including a series conducted at the Wharton School of Finance, is remarkably uniform. Investors have done no better with the average mutual fund than they could have done by purchasing and holding an unmanaged broad stock index. In other words, over long periods of time mutual-fund portfolios have not outperformed randomly selected groups of stocks. While funds may have very good records for certain short time periods, there is generally no consistency to superior performance. The only dependable relationship in mutual-fund performance is the tendency for funds assuming greater risks to earn, on average, a larger long-run rate of return.
One of the most widely accepted propositions in the field of investment is that on average investors should receive higher rates of return for bearing greater risk. Risk is considered to be the relative volatility of returns. An investment promising a stable and dependable 9 percent each year is less risky than (and preferable to) one that may return 36 percent in a year when the market is strong and lose 18 percent in a year when the market falls. At least this seems to be the view of the majority of investors. Return in this context is composed of both dividends and any appreciation (or depreciation) in the market value of the shares held.
Few, if any, investors can fail to be concerned with the downside risk of their investments, especially if they may be forced to sell during a bear market. And because downside risk is so universally distasteful, investors who hold portfolios of riskier shares, whose price swings are wider, must be and actually are compensated with a somewhat higher long-run return.
The differences that do exist in mutual-fund returns can often be explained almost entirely by differences in the risk they have taken.
Risk is measured by the relative sensitivity of the fund’s performance to swings in the general market. A fund that tends to do very well when the market goes up but falls out of bed when the market falters gets a high risk rating. A fund with more stable returns from year to year gets a low risk rating. By and large the riskiest funds – the growth-oriented news – have the largest average return. But these are also the funds whose annual returns are most volatile and that fell most sharply when the market turns sour. The safest funds – those balanced with short- and intermediate-term fixed-income securities – tend to have the lowest but most stable returns. To be sure, over the whole period (including up and down markets) the more volatile funds outdistance their safer counterparts and even tend to do better than a broad stock-market average. But this was not a matter of skill – added risk was the price of that performance. Randomly selected portfolios of riskier stocks also tend to outdistance the market. Indeed, you could have bought the stocks making up the market average (say, the S&P 500) on margin (that is, borrowing some of the funds needed to pay for the purchase) and increased both your risk and your return. If you held one of the supposedly better-performing but riskier funds, don’t ascribe this to any genius on the fund manager’s part. You extra return was simply a just reward due you for bearing extra risk.
In addition to the scientific evidence that has been accumulated, several less formal tests have verified this finding. In June 1967, the editors of Forbes magazine, for example, intrigued with the results of academic studies, chose a portfolio of common stocks by throwing darts at the stock-market page of the New York Times. They struck 28 names and constructed a simulated portfolio consisting of a $1,000 investment in each stock. Seventeen years later, in mid-1984, that $28,000 portfolio (with all dividends reinvested) was worth $131,697,61. The 370 percent gain easily beat the broad market indices. Moreover, the 9.5 percent annual compounded rate of return has been exceeded only by a minuscule number of professional money managers. Does this mean that the wrist is mightier than the brain? Perhaps not, but I think that the Forbes editors raised a very valid question when they wrote: “It would seem that a combination of luck and sloth beats brains.” (Forbes retired the dart-board fund in 1984 because “the merger and takeover waves eliminated too many of its stocks; only 15% of the original 28 companies remained.)
How can this be? Every year one can read the performance rankings of mutual funds. These always show many funds beating the averages – some by significant amounts. The problem is that there is no consistency to the performances. A manager who has been better than average one year has only a 50 percent chance of doing better than average the next year. Just as past earnings growth cannot predict future earnings, neither can past fund performance predict future results. Fund managements are also subject to random events – they may grow fat, become lazy, or break up. An investment approach that works very well for one period can easily turn sour the next. One is tempted to conclude that a very important factor in determining performance ranking is our old friend Lady Luck.
To shed further light on this issue, let’s remind you that performance investing was a product of the 1960s and became especially prominent during the 1967-68 strong bull market. Capital preservation had given way to capital productivity. The fund managers who turned in the best results for the period were written up in the financial press like sports celebrities. When the performance rankings were published in 1967 and 1968, the go-go funds with their youthful gunslingers as managers and concept stocks as investments were right at the top of the pack, outgunning all the competition by a wide margin.
The game ended unceremoniously with the bear market that commenced in 1969 and continued until 1971. The go-go funds suddenly went into reserve. It was fly now and pay later for the performance funds. Their portfolios of volatile concept stocks were no exception to the financial law of gravitation. They wen down just as sharply as they had gone up. The legendary brilliance of the fund managers turned out to be mainly a legend of their own creation. The top funds of 1968 had a perfectly disastrous performance in the ensuing years, and many of funds active in 1974 were no longer in business after 1974.
The Mates Fund, for example, was number one in 1968. At the end of 1974, the Mates Fund sold at about one-fourteenth of its 1968 value and Mates finally threw in the towel. He then left the investment community to enter a business catering to a new fad. In New York City he started a single’s bar, appropriately named “Mates”.
It seems clear that one cannot count on consistency of performance. Portfolio managers do not consistently outdistance their rivals. But I must be fair: There are exceptions to the rule. For example, the Templeton Growth Fund has been a superior performer in many periods of time. It is an excellent counterexample to the rule – but such examples are very rare. Indeed, the number of funds that have outperformed randomly selected portfolios with equivalent risk is no larger than might be attributed to chance.
In any activity in which large numbers of people are engaged, while the average is likely to predominate, the unexpected is bound to happen. The very small number of really good performers we find in the investment management business is not at all inconsistent with the laws of chance. Indeed, the fact that good past performance of a mutual fund is no help whatever in predicting future performance only serves to emphasize this point.
Perhaps the laws of chance should be illustrated. Let’s engage in a coin-tossing contest. Those who can consistently flip heads will be declared winners. The contest begins and 1,000 flip coins. Just as would be expected by chance, 500 of them flip heads and these winners are allowed to advance to the second stage of the contest and flip again. As might be expected, 250 flip heads. Operating under the laws of chance, there will be 125 winners in the third round, 63 in the fourth, 31 in the fifth, 16 in the sixth, and 8 in the seventh.
By this time, crowds start to gather to witness the surprising ability of these expert coin-tossers. The winners are overwhelmed with adulation. They are celebrated as geniuses in the art of coin-tossing – their biographies are written and people urgently seek their advice. After all, there were 1,000 contestants and only 8 could consistently flip heads. The game continues and there are even those who eventually flip heads nine and ten times in a row. (If we had let the losers continue to play (as mutual-fund managers do, even after a bad year), we would have found several more contestants who flipped eight or nine heads out of ten and were therefore regarded as expert tossers). The Point of this analogy is not to indicate that investment-fund managers can or should make their decisions by flipping coins, but that the laws of chance do operate and they can explain some amazing success stories.
As long as there are averages, some people will beat them. With large numbers of players in the money game, chance will – and does – explain some super performance records. The very great publicity given occasional success in stock selection reminds me of the famous story of the doctor who claimed he had developed a cure for cancer in chickens. He proudly announced that in 33 percent of the cases tested remarkable improvement was noted. In another third of the cases, he admitted, there seemed to be no change in condition. He then rather sheepishly added, “And I’m afraid the third chicken ran away.”
While the preceding discussion has focused on mutual funds, it should not be assumed that the funds are simply the worst of the whole lot of investment managers. In fact, the mutual funds have had a somewhat better performance record than many other professional investors. The records of life insurance companies, property and casualty insurance companies, pension funds, personal trusts administrated by banks, and individual discretionary accounts handled by investment advisers have all been studied. This research suggests that there are no sizable differences in investment performance among these professional investors or between these groups and the market as a whole. As in the case of the mutual funds there are some exceptions, but again they are very rare. No scientific evidence has yet been assembled to indicate that the investment performance of professionally managed portfolios as a group has been any better than that of randomly selected portfolios.
Many people asked me how this thesis – first published in 1973 – has help up. The answer is, “Very well indeed.” While there continue to be some exceptions to the thesis, as I freely admitted in 1973, history has been very kind to random walkers. The table below makes the case as well as any. In the fifteen-year period to 1990, over two-thirds of the professionals who manage pension-fund common-stock portfolios were out-performed by the unmanaged Standard & Poor’s 500-Stock Indes (These data were provided by SEI Funds Evaluation – formerly A.G.Becker). And, as we have just read, the Forbes Dart-Board Fund significantly outperformed both the unmanaged averages and the professionally managed funds:
Pension Funds Outperformed by S&P 500-Stock Index
Time period: 15 years to 1990
Return Median Pension Fund (percent): 14.8
Return S&P 500 (Percent) 16.5
Percentage Accounts Outperformed by S&P 500: 70.
Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.
