Fees and Mutual Fund Returns
4.7 Mutual Fund Investment Performance: A First Look
ETFs offer several advantages over conventional mutual funds. First, as we just noted, a mutual fund’s net asset value is quoted—and therefore, investors can buy or sell their shares in the fund—only once a day. In contrast, ETFs trade continuously. Moreover, like other shares, but unlike mutual funds, ETFs can be sold short or purchased on margin.
ETFs also offer a potential tax advantage over mutual funds. When large numbers of mutual fund investors redeem their shares, the fund must sell securities to meet the redemp- tions. This can trigger capital gains taxes, which are passed through to and must be paid by the remaining shareholders. In contrast, when small investors wish to redeem their position in an ETF, they simply sell their shares to other traders, with no need for the fund to sell any of the underlying portfolio. Large investors can exchange their ETF shares for shares in the underlying portfolio; this form of redemption also avoids a tax event.
ETFs are often cheaper than mutual funds. Investors who buy ETFs do so through brokers rather than buying directly from the fund. Therefore, the fund saves the cost of marketing itself directly to small investors. This reduction in expenses may translate into lower management fees.
There are some disadvantages to ETFs, however. First, while mutual funds can be bought at no expense from no-load funds, ETFs must be purchased from brokers for a fee. In addition, because ETFs trade as securities, their prices can depart from NAV, at least for short periods, and these price discrepancies can easily swamp the cost advan- tage that ETFs otherwise offer. While those discrepancies typically are quite small, they can spike unpredictably when markets are stressed. Chapter 3 briefly discussed the so-called flash crash of May 6, 2010, when the Dow Jones Industrial Average fell by 583 points in seven minutes, leaving it down nearly 1,000 points for the day. Remark- ably, the index recovered more than 600 points in the next 10 minutes. In the wake of this incredible volatility, the stock exchanges canceled many trades that had gone off at what were viewed as distorted prices. Around one-fifth of all ETFs changed hands on that day at prices less than one-half of their closing price, and ETFs accounted for about two-thirds of all canceled trades.
At least two problems were exposed in this episode. First, when markets are not work- ing properly, it can be hard to measure the net asset value of the ETF portfolio, especially for ETFs that track less liquid assets. And, reinforcing this problem, some ETFs may be supported by only a very small number of dealers. If they drop out of the market during a period of turmoil, prices may swing wildly.
We noted earlier that one of the benefits of mutual funds for the individual investor is the ability to delegate management of the portfolio to investment professionals. The investor retains control over the broad features of the overall portfolio through the asset allocation decision: Each individual chooses the percentages of the portfolio to invest in bond funds versus equity funds versus money market funds, and so forth, but can leave the specific security selection decisions within each investment class to the managers of each fund.
Shareholders hope that these portfolio managers can achieve better investment perfor- mance than they could obtain on their own.
What is the investment record of the mutual fund industry? This seemingly straightfor- ward question is deceptively difficult to answer because we need a standard against which to evaluate performance. For example, we clearly would not want to compare the invest- ment performance of an equity fund to the rate of return available in the money market.
The vast differences in the risk of these two markets dictate that year-by-year as well as
average performance will differ considerably. We would expect to find that equity funds outperform money market funds (on average) as compensation to investors for the extra risk incurred in equity markets. How then can we determine whether mutual fund portfolio managers are performing up to par given the level of risk they incur? In other words, what is the proper benchmark against which investment performance ought to be evaluated?
Measuring portfolio risk properly and using such measures to choose an appropriate benchmark is far from straightforward. We devote all of Parts Two and Three of the text to issues surrounding the proper measurement of portfolio risk and the trade-off between risk and return. In this chapter, therefore, we will satisfy ourselves with a first look at the question of fund performance by using only very simple performance benchmarks and ignoring the more subtle issues of risk differences across funds. However, we will return to this topic in Chapter 11, where we take a closer look at mutual fund performance after adjusting for differences in the exposure of portfolios to various sources of risk.
Here we use as a benchmark for the performance of equity fund managers the rate of return on the Wilshire 5000 index. Recall from Chapter 2 that this is a value-weighted index of essentially all actively traded U.S. stocks. The performance of the Wilshire 5000 is a useful benchmark with which to evaluate professional managers because it corresponds to a simple passive investment strategy: Buy all the shares in the index in proportion to their outstanding market value. Moreover, this is a feasible strategy for even small inves- tors, because the Vanguard Group offers an index fund (its Total Stock Market Portfolio) designed to replicate the performance of the Wilshire 5000 index. Using the Wilshire 5000 index as a benchmark, we may pose the problem of evaluating the performance of mutual fund portfolio managers this way: How does the typical performance of actively managed equity mutual funds compare to the performance of a passively managed portfolio that simply replicates the composition of a broad index of the stock market?
Casual comparisons of the performance of the Wilshire 5000 index versus that of professionally managed mutual funds reveal disappointing results for active managers.
Figure 4.4 shows that the average return on diversified equity funds was below the return on the Wilshire index in 27 of the 45 years from 1971 to 2015. The average annual return on the index was 12.1%, which was 1% greater than that of the average mutual fund.6
This result may seem surprising. After all, it would not seem unreasonable to expect that professional money managers should be able to outperform a very simple rule such as
“hold an indexed portfolio.” As it turns out, however, there may be good reasons to expect such a result. We explore them in detail in Chapter 11, where we discuss the efficient market hypothesis.
Of course, one might argue that there are good managers and bad managers, and that good managers can, in fact, consistently outperform the index. To test this notion, we ask whether managers with good performance in one year are likely to repeat that performance in a following year. Is superior performance in any particular year due to luck, and there- fore random, or due to skill, and therefore consistent from year to year?
To answer this question, we can examine the performance of a large sample of equity mutual fund portfolios, divide the funds into two groups based on total investment return, and ask: “Do funds with investment returns in the top half of the sample in one period continue to perform well in a subsequent period?”
6Of course, actual funds incur trading costs while indexes do not, so a fair comparison between the returns on actively managed funds versus those on a passive index should first reduce the return on the Wilshire 5000 by an estimate of such costs. Vanguard’s Total Stock Market Index portfolio, which tracks the Wilshire 5000, charges an expense ratio of less than .10%, and, because it engages in little trading, incurs low trading costs. Therefore, it would be reasonable to reduce the returns on the index by about .15%. This reduction would not erase the difference in average performance.
-40 -30 -20 -10 0 10 20 30 40
Rate ofReturn (%)
Active Funds Wilshire 5000
1971 1975 1979 1983 1987 1991 1995 1999 20072003 2011 2015
Figure 4.4 Rates of return on actively managed equity funds versus Wilshire 5000 index, 1971–2015
Source: For Wilshire returns, see www.wilshire.com. For active fund returns, see SPIVA U.S. Scorecard, S&P Dow Jones Indices Research.
Table 4.4 presents such an analysis from a study by Malkiel.7 The table shows the frac- tion of “winners” (i.e., top-half performers) in each year that turn out to be winners or los- ers in the following year. If performance were purely random from one period to the next, there would be entries of 50% in each cell of the table, as top- or bottom-half performers would be equally likely to perform in either the top or bottom half of the sample in the following period. On the other hand, if performance were due entirely to skill, with no randomness, we would expect to see entries of 100% on the diagonals and entries of 0% on the off-diagonals: Top-half performers would all remain in the top half, while bottom-half
7Burton G. Malkiel, “Returns from Investing in Equity Mutual Funds 1971–1991,” Journal of Finance 50 (June 1995), pp. 549–72.
Table 4.4
Consistency of investment results
Successive Period Performance Initial Period Performance Top Half Bottom Half A. 1970s
Top half 65.1% 34.9%
Bottom half 35.5 64.5
B. 1980s
Top half 51.7 48.3
Bottom half 47.5 52.5
Source: Burton G. Malkiel, “Returns from Investing in Equity Mutual Funds 1971–1991,”
Journal of Finance 50 (June 1995), pp. 549–72.
performers similarly would all remain in the bottom half. In fact, looking at the 1970s data in Panel A, the table shows that 65.1% of initial top-half performers fall in the top half of the sample in the following period, while 64.5% of initial bottom-half performers fall in the bottom half in the following period. This evidence is consistent with the notion that at least part of a fund’s performance is a function of skill as opposed to luck, so that relative performance tends to persist from one period to the next.8
On the other hand, this relationship does not seem stable across different sample periods. While initial-year performance predicts subsequent-year performance in the 1970s (Panel A), the pattern of persistence in performance virtually disappears in the 1980s (Panel B). To summarize, the evidence that performance is consistent from one period to the next is suggestive, but it is inconclusive.
Other studies suggest that there is little performance persistence among professional managers, and if anything, bad performance is more likely to persist than good perfor- mance.9 This makes some sense: It is easy to identify fund characteristics that will result in consistently poor investment performance, notably high expense ratios, and high turnover ratios with associated trading costs. It is far harder to identify the secrets of successful stock picking. (If it were easy, we would all be rich!) Thus the consistency we do observe in fund performance may be due in large part to the poor performers. This suggests that the real value of past performance data is to avoid truly poor funds, even if identifying the future top performers is still a daunting task.
8Another possibility is that performance consistency is due to variation in fee structure across funds. We return to this possibility in Chapter 11.
9See for example, Mark M. Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance 52 (1997), 57–82. Carhart’s study also addresses survivorship bias, the tendency for better-performing funds to stay in business and thus remain in the sample. We return to his study in Chapter 11.
Suppose you observe the investment performance of 400 portfolio managers and rank them by investment returns during the year. Twenty percent of all managers are truly skilled, and therefore always fall in the top half, but the others fall in the top half purely because of good luck. What fraction of this year’s top-half managers would you expect to be top-half performers next year?
Concept Check 4.4
The first place to find information on a mutual fund is in its prospectus. The Securities and Exchange Commission requires that the prospectus describe the fund’s investment objectives and policies in a concise “Statement of Investment Objectives” as well as in lengthy discus- sions of investment policies and risks. The fund’s investment adviser and its portfolio manager are also described. The prospectus also presents the costs associated with purchasing shares in the fund in a fee table. Sales charges such as front-end and back-end loads as well as annual operating expenses such as management fees and 12b-1 fees are detailed in the fee table.
Funds provide information about themselves in two other sources. The Statement of Additional Information (SAI), also known as Part B of the prospectus, includes a list of the securities in the portfolio at the end of the fiscal year, audited financial statements, a list of the directors and officers of the fund (as well as their personal investments in the fund),