Thursday, August 31, 2006

Do Mutual Funds Perform When it Matters Most?

I appreciate your patience with me as I have taken a bit of a break from blogging to catch up on some administrative necessities.

However, having read a fascinating article, I could not wait to bring it to your attention.

The combined assets of U.S. mutual funds totals some $9.4 trillion of which about $5.2 trillion is stock funds. Year to date cash flows have been about $110 billion of inflows into stock mutual funds.

Mutual fund underperformance has been widely documented by both the popular press and academic research. Though historically much of the underperformance has been attributed to poor stock-picking by professional money managers, more recent research has attributed the phenomenon to poor portfolio composition and excessive portfolio turnover. The high portfolio churn leads to after-tax performance that further reduces returns.

Noted thinkers such as Charlie Ellis argue that it is exceedingly difficult for institutionalal investors to outperform the market when, in aggregate, they actually are the market. John Bogle, of Vanguard fame, has similar thoughts, essentially that all investors, in aggregate earn precisely the market return before the costs of investment are subtracted. And management fees, transaction costs, distriubtion costs are substantial, particularly given current relatively low rates of return.

But this paper counters some of the negatave arguments that have long been attributed to the industry. The study, written by Robert Kosowski of INSEAD covers the U.S. domestic equity
industry for the period 1962-2005.

The paper demonstrates that indeed, during periods of expansion, the mutual fund industry, in general, fails to generate alpha...the risk-adjusted return is less than the benchmark index return. However, in periods of recession, the industry on balance achieves positive alpha, a risk-adjusted return greater than the benchmark.

During recessions, investors' marginal utility of wealth is other words, there is much greater sensitivity about loss of wealth. At such a time, the mutual fund industry is more likely to show positive alpha and enhanced returns.

The difference in alpha between expansionary and recessionary years is very significant amounting to 3 to 5% a year. The sudy also addressed the performance differences between aggressive growthm growth, growth and income, and balance or income fund classifications.

Please review the numbers in the spreadsheet posted prior to this post. The numbers are quite astounding.

During recessionary periods, balanced mutual funds in aggregate generated over 500 basis points of alpha on a risk-adjusted basis! Quite impressive! Aggressive growth mutual funds generated the least positive alpha as a category, but nevertheless, on a risk-adjusted basis, they did generate 82 basis points of alpha in aggregate. However, in every category, over the long run, managers fail to generate alpha.

Once again, the evidence is strong...most mutual funds subtract rather than add value over the long run. Clearly, there are exceptions to this, generally from low-turnover, disciplined funds. The real surprise is that most of the industry adds value when you need it most! Hence, it is possible to exploit business cycle predictability to achieve positive risk-adjusted returns from mutual funds.

The evidence is somewhat encouraging for recessions...but a quandary remains. How good is the investor at forecasting recessions?


At 4:13 PM, Blogger Jay Walker said...


Unfortunately, it reminds me of a strategy I once read about why winning baseball teams win.

There's certain teams with a strategy (they have, let's say, a below average talent pool) to limit opposition runs, and to try to get on base with at least singles. This is the defensive game: the parallel is the mutual funds when the market is declining.

However, these teams are generally beaten by others who aren't as consistent at defence, but are much better at getting "one good inning" at bat. The number of runs scored there is often enough to win the game alone. This reminds me that moving up MORE when the market is also moving up, is what really gets you your investing victories.

Perhaps this doesn't translate well to investing, but it seems to me to be an apt analogy to how to win long term.

On the other hand, Buffett says Rule 1 is "don't lose your capital" and Rule 2 is "don't forget Rule 1"



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