Evidence

Overview

Let’s state the matter directly. The academic evidence (which we review below) strongly indicates that the attempt of mutual funds to add value for their customers (through research, analysis, etc.) is a costly misadventure (for the customer, that is, not the mutual fund). The Costs simply exceed the benefits.

The academic evidence indicates that investors should rightfully (if they properly understood the matter) refuse to allow mutual funds to make this attempt in their behalf and at their (the investors’) expense.

The academic evidence indicates investors would, rather, enhance their investment returns through the utilization of low cost index funds and a focus on a proper asset allocation process.

Professor Malkiel’s Thesis

In the Preface to the 1998 edition of his seminal work, A Random Walk Down Wall Street, Princeton Economics Professor Burton G. Malkiel writes:

“It has now been close to thirty years since I began writing the first edition of A Random Walk Down Wall Street. The message of the original edition was a very simple one: Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds. I boldly stated that buying and holding all the stocks in a broad, stock-market average-as index funds do-was likely to outperform professionally managed funds whose high expense charges and large trading costs detract substantially from investment returns.

Now, some thirty years later, I believe even more strongly in that original thesis, and there’s more than a six-figure gain to prove it.”

Later in the Preface, Professor Malkiel continues as follows:

“This edition takes a hard look at the basic thesis of earlier editions of Random Walk-that the market prices stocks so efficiently that a blindfolded chimpanzee throwing darts at the Wall Street Journal can select a portfolio that performs as well as those managed by the experts. Through the past thirty years that thesis has held up remarkably well. More than two-thirds of professional portfolio managers have been outperformed by the unmanaged S&P 500-Stock Index.” (Emphasis Added By IFE).

Finally, to put all this in hard dollar terms, Professor Malkiel’s preface includes a chart comparing $10,000 invested in the average general equity (stock) fund to $10,000 invested in a S&P 500 Index Fund over the same period. (See Types of Index Funds for more information on this and other index funds). The results of Professor Malkiel’s study: $311,000 for the index fund, $171,950 for the average general equity fund, a difference of almost $140,000 or a net higher performance of nearly 80.86% over the 30 year period from 1969 through 1998. (Emphasis Added By IFE).

If you are not thrown back in your chair from reading the above paragraphs, go back and look again. If you are not then thrown back in your chair, go back and look a third time. We are shooting for no less than the “ah-hah” experience, the epiphany, the revelation. Many other academic studies confirm Professor Malkiel’s work (see below). As you will see, the structure of the studies may vary. The data periods may vary. Nonetheless, the key fact remains: mutual funds have consistently underperformed the very indexes (and index funds that mirror those indexes) against which they measure or “compare” their success. The implications of this fact for investment decision-making is enormous, in fact, revolutionary.

In Professor Malkiel’s work, the “comparative” index fund is an S&P 500 Index Fund, an index fund that reflects 500 of the largest, most established, domestic (US) companies. This is to say that the self-defined primary investment goal for these general equity mutual funds is to be able to add value to investors above the return available from simply “buying the index”. Yet, as we learned from Professor Malkiel’s work (and other studies reviewed below), the performance of these general equity funds as a group has substantially lagged that of the very index they generally utilize as their benchmark.

This historical underperformance is not encouraging data for an investment industry that premises itself on the ability to enhance returns for investors.

More Evidence Against Managed Mutual Funds (and In Favor of Index Funds)

Other academic studies have come to the same essential conclusion of Professor Malkiel regarding the failure of active management to add value in excess of the cost incurred in the attempt to do so.

In Larry E. Swedroe’s phenomenal book, Rational Investing In Irrational Times (2002), Mr. Swedroe reviews much of the academic work regarding the inability of fund managers to add value over index funds. Consider the following from Mr. Swedroe’s book:

“Mark Carhart’s classic study of the mutual fund industry determined that once you accounted for style factors (small cap versus large cap and value versus growth), the average actively managed fund underperformed its benchmark on a pretax basis by 1.8% per annum.(3) Another exhaustive study by Russ Wermers, published in the August 2000 issue of the Journal of Finance, came to a virtually identical conclusion.”

3. Mark M. Carhart, “On Persistence in Mutual Fund Performance,” doctoral dissertation, University of Chicago, December 1994.

Mr. Swedroe continues as follows:

“To gain further perspective on active management, let’s take a longer-term look at the performance against two benchmarks, the Wilshire 5000 and the Russell 3000, that are broader indices than the S&P 500 Index. For the five-, ten-and fifteen-year periods ending 2000 only sixteen percent, sixteen percent, and seventeen percent of actively managed funds outperformed the Russell 3000.”(4)

4. The Index Insider (January 2001).

Still More Evidence: John C. Bogle and The Bogle Center for
   Investment Research

The Bogle Center for Investment Research researches index fund performance. In a study published in the Journal of Portfolio Management (Spring 2002, Volume 28, Number 3), John C. Bogle, the founder of the Bogle Center presented a study on index fund performance entitled An Index Fundamentalist Goes Back to the Drawing Board.

This study was a follow-up on an early study prepared in 1997 and sought to extend the analysis. The new study covered the 10-year period ending June 30, 2001. As in the earlier study, this study analyzed the performance of index funds against managed mutual funds. Also, as in the earlier study, this study examined the relevant data in the nine Morningstar style box sub-categories of equity mutual funds. In this Morningstar framework, equity mutual funds are divided into a “matrix with large-, mid-, and small-capitalization funds on one axis and value, blend, and growth funds on the other.” Essentially, the study examined index fund performance relative to managed mutual funds in the various “styles” or sub-asset classes to see if the anticipated better performance of index funds would be consistent across all primary equity asset classes.

Not surprisingly, the study found that (in total) Index Funds outperformed All Funds by 14.4% per year to 13.7% per year. But, this understates the performance superiority of Index Funds. First, the study did not adjust for “survivorship bias”, (see more on this important topic below) a substantial performance distortion in favor of mutual funds. The study itself estimates the overstatement of average mutual fund performance from “survivorship bias” by 2% per year. Secondly, the study ignored substantial elements of investment “costs” focussing on the more limited “expense ratio” only. (See Costs for a fuller discussion of the various components of this most vital factor in investment performance.) Adjusting for the missing components of Costs would clearly have substantially further reduced All Funds results in contrast to Index Funds. It should also be noted that the study indicated a higher risk factor for All Funds as compared to Index Funds.

In terms of investment “style” or asset class differences, the study examined “risk-adjusted” returns for the nine Morningstar style categories discussed above. The results: in all but one category (small-cap growth) did the risk adjusted performance of All Funds (of that particular category) outperform the comparable (small-cap growth) Index Funds category. In all other eight categories (and despite the substantial performance distortions in favor of All Funds discussed below) the risk-adjusted performance victory went to the Index Funds.

Still More Evidence: International Performance Data

Finally, for some international flavor, consider a study performed by WM Company of Great Britain (and reported by Index Investor, Inc.) This study analyzed the performance of UK unit trusts over a twenty-year period ending December 31, 2000. The performance of these trusts was compared to the performance of the FTSE All-Share Index, a broad market index.

The study found the following:

“(O)ver the twenty year period, of 55 actively managed unit trusts with 20-year performance records, only eleven (20% outperformed the index. Over the twelve years to the end of 2000 for which comparable data was available, the average tracker fund returned was greater than 70% of the active trusts.”

A tracker fund is what we in the United States would call an index fund. Note that similar to Professor Malkiel’s data with which we began this section on Evidence, Index Funds in Great Britain outperformed more than 2/3 of active managers, even before factoring in “survivorship bias” (see below).

Summary of Performance Studies

Slice it, dice it, any way you like. Examine general equity funds or more specialized funds. Look at mutual fund managers or pension fund managers. Look at domestic data or international data. All the reputable studies point to the same conclusion: paying so called “money experts” big dollars in the hopes that such experts will enhance your investment returns in excess of the comparable index or index fund is a false and costly belief. (See Investment Illusion elsewhere on this web site for a fuller discussion on the mechanism of these false belief structures.)

But Wait, Performance of Mutual Fund Managers is Actually Even Worse Than The Studies Show

As bad (for the mutual fund industry) as are the results of the numerous above referenced performance studies, two other lines of academic study shows these studies to understate the matter: Survivorship Bias and the Fallacy of Persistency. We discuss both below.

Survivorship Bias

The underperformance of mutual funds relative to Index Funds is actually significantly understated in the above studies of long-term mutual fund performance. This is because of a phenomenon known as survivorship bias which distorts the historical performance analysis in favor of “surviving” mutual funds by conveniently discarding the performance of those funds that have been merged out of existence. To review the data on this distortion of historical mutual fund performance, click on Survivorship Bias. Here we simply point out the impact. Once survivorship bias is taken into account, the average mutual fund has performed 1.5% or so annually worse that the already poor performance numbers indicated in the above studies.

The Fallacy of Persistency or Why Even Those Funds Who Performed Well Historically Are Unlikely to Do So Again

Finally, for those who cling to some belief that, while the average performing mutual fund is bad, the “good funds” (if you just pick them right) add value, we review the studies on persistency of superior performance. (See the Fallacy of Persistency elsewhere on this web site). This body of research is also quite surprising as the data suggest scant support for a belief that good performance persists. Rather, there is convincing evidence that last period’s top performers will not be the top performers in the future, only average performers or worse.

Conclusions from the Data

As you cycle through the academic studies concerning historical performance, survivorship bias, and the fallacy of persistency, that is to say, the facts of the matter, you should arrive at two undeniable overarching impressions: Poor performance of most mutual funds and no reason to believe that the successful ones were successful for any other reason than pure randomness (See Fooled by Randomness, elsewhere on this web site). Together, these two “realities” argue strongly against entrusting your hard-earned money to a managed mutual fund company. Better, (you will discover) that you should simply buy an “index” fund that mirrors a particular basket of securities (an index) and save on the substantial Costs that the managed mutual funds charge in their hapless attempt to add value over that of owing just the benchmark index itself.

In conclusion, let’s emphasize this last point! If the attempt to add value was not costly, perhaps you, as an investor, could condone this attempt by mutual fund managers to produce superior returns. But YOU’RE PAYING FOR THE MISADVENTURES OF THE MUTUAL FUND MANAGERS. Why do they (the average managed mutual fund) want you to let them try? That’s a no-brainer! It’s 1% (or whatever the particular advisory fee of the particular mutual fund happens to be) of say a billion dollars per year (or whatever the size of the particular fund). But why would you let them do this with your money. That’s an entirely other question, for the Costs are substantial. Don’t be roped in. Ignore the investment hoopla. Instead, focus on those elements of investment that matter, controlling expenses (through the use of low cost index funds) and engaging in proper asset allocation, where attention is paid to the blend of asset classes rather than the ill-advised, illusional, and costly attempt to garner superior returns in any particular asset class.