8 Myths
8 Myths Killing Portfolio Performance
Can you answer these questions. Do active investors (and active money managers) perform better than stock market rates of return by actively trading individual stocks? Can active money managers know when to be in and out of the market? Why do investors’ portfolios underperform in both bull and bear markets?
It is easy to get opinions on questions of this type. It is hard to get facts. The answers are based on results that can be measured. We help clients have peace of mind from the responsibilities of dealing with the complexities of investing by answering questions of this type. Here are the answers.
Myth 1: Believing that the expenses of active management don’t matter
Active investing is the attempt of either an individual or a money manager to try and out-perform the stock market rates of return by actively trading individual stocks and/or engaging in market timing – predicting when to be invested (in the market) or not be invested (out of the market.)
In order for an active mutual fund managers to beat the market they must perform better than their comparative benchmark. For example a large cap mutual fund would be compared to the S&P 500 index. Because they are attempting to beat the index they are going to incur some additional fees in their attempt. And so they must beat their benchmark while including fees, taxes, trading costs, etc. Active trading creates an undisclosed fee to investors called transaction costs and bid/ask spreads. There have been many studies done to show investors what this active trading costs investors. On average this active trading costs investors an additional 1.44%
per year. This in addition to the funds management expense ratio (MER). The MER typically includes management fees, 12b-1 fees, and other expenses deducted from fund assets or charged to all investors accounts (U.S. Securities and Exchange Commission 2000.) The average MER for equity mutual funds is 1.45%
per year, which together with an average trading cost of 1.44%, renders a total annual fund cost of 2.89% per year for the average active mutual fund.
Ken French of Dartmouth’s Tuck School of Business estimates that investors collectively spent $102 billion per year in trying to achieve above-market rates of return. We do not use actively traded mutual funds!
Myth 2: Believing that active mutual fund managers can beat the market
As you can see from this next chart the vast majority of active mutual fund managers have failed to beat the market.
This chart also tells us that some active managers were able to beat the market. Because of this fact we are lead to ask, was it luck or skill? To answer this question we took the 30 top-performing active mutual funds from 1990 to 1990. These 30 active funds delivered significantly higher returns, 27.15 percent versus the S&P 500 of 18.89 percent.5 How well do you think these same top 30 funds did over the next 10 years, from 2000-2009? These 30 funds delivered lower returns, negative -4.43 percent versus the S&P 500 benchmark did 1.21 percent.5 They all underperformed the Market as a whole. The answer to the question is, luck. (We do not use actively managed mutual funds.)
TO READ MORE PLEASE REQUEST OUR FREE WHITE PAPER TITLED “8 MYTHS KILLING PORTFOLIO PERFORMANCE” Please click here
1 Virginia Tech University and Boston College “Scale Effects in Mutual Fund Performance.” The role of Trading Cost” examined 1,706 U.S. stock funds from 1995 to 2005. Another study by Edelen, Evans, and Kadlec (2009), in a survey of 1,758 U.S. equity funds, found that trading costs were 144 bps.
2 Morningstar Principia dated 12/31/09 and DFA Return Software dated 12/31/2009
3 Barras, Laurent, Scailet, wermers, and Russ, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas” (May 2008). Robert H. Smith School Research Paper No. RHS 06-043 Available at SSRN: http://ssm.com/abstract=869748
4 Source: Standard & Poor’s Indices Versus Active Funds Scorecard, March 30, 2010. Indicies used for comparison: US Large Cap–S&P 500 Index, US Small Cap-S&P 600 Index, International – S&P 700 Index, International Small – S&P Developed ex. -US Small Cap Index, Emerging Markets – S&P IFCI Composite. Data for the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database. Results are net of fees and expenses. Indicies are not available for direct invstment. January 1, 2005 – December 31, 2009
5 Average of all US Equity funds available in the CRSP Survivor-Bias Free US Mutual Fund Database, date ending Dec. 2009. S&P 500 Index data obtained from DFA Returns softward 12/09
