Is it possible for fund managers to beat the stock market?

Nearly anyone with money in the stock market since 2009 has benefited from the great bull market run. But compared with the overall market, most actively managed stock mutual funds haven't performed very well or very consistently.

Exactly how the funds stack up will depend on the precise measurements you use. If you use the definitions and updated results of a study that I reported on last month, actively managed stock funds as a group look quite weak. In fact, in the six years until March, they did worse than you would have expected if their managers had flipped coins instead of picking stocks.

That study, Does Past Performance Matter? The Persistence Scorecard, by S&P Dow Jones Indices, asked whether good performance in one year persisted in the years that followed. It generally didn't. Not a single actively managed fund finished in the top quarter in each of the six years up to March 2015.

But, as many readers pointed out, there are other ways of evaluating mutual funds.

Perhaps the most basic is to run a bake-off between actively managed funds and benchmark indexes to see which funds win. As it happens, S&P Dow Jones Indices, which ran the other study, has also run these contests regularly since 2002.

In these matchups, actively managed domestic stock funds as a group often looked better than they did in the probability-based study in which they performed so miserably. But even in these contests with benchmark indexes, the overall picture isn’t pretty.

Most of the actively managed funds performed erratically. In some years, a majority beat their benchmarks, but they failed to do so over extended periods. Like the other studies, these contests seem to strengthen the case for investing in broad, low-cost index funds that don’t try to beat the market but merely try to match it.

The S&P Dow Jones group calls its semiannual contest the Spiva Scorecard (Spiva is an abbreviation for S&P Indices versus active). The latest report, released last month, showed that in six of 15 years since 2000, most actively managed mutual funds beat a broad benchmark, the Standard & Poor’s 1,500-stock index, which serves as a proxy for the overall stock market in the United States. (The S&P 1,500 includes all the stocks in the S&P 500, S&P MidCap 400 and S&P SmallCap 600 indexes, representing companies of all types and sizes.)

The actively managed funds came out on top as recently as 2013 and lost to the broad index in 2014. Based on the recent calendar-year returns alone, you might conclude the actively managed funds have been holding their own.

But the longer-term results are telling: over the three years to December, the index beat 76.8 per cent of the actively managed domestic stock funds. Over five years, it outdid 80.8 per cent of them. Over 10 years, it beat 76.5 per cent. Put simply, at least three-quarters of those actively managed mutual funds regularly failed to beat the broad market index over three, five and 10 years. This underperformance has persisted year after year.

“We’ve consistently found those kinds of results,” said Aye M Soe, senior director of index research and design for S&P Dow Jones Indices, who has been conducting the study since 2002.

What’s more, at my request, the researchers reran the entire study, eliminating the effects of expenses, as captured by the funds’ expense ratios. Even without expenses, they found nearly all actively managed domestic stock funds trailed the benchmarks over three, five and 10 years. Large-cap funds were the single exception, and only over 10 years.

‘Survivorship bias’

Using a database developed at the University of Chicago, known as CRSP, for the Center for Research in Security Prices, the study avoided what is known as “survivorship bias”, Soe said. For example, the latest Spiva Scorecard examined the performance and characteristics of 2,080 actively managed mutual funds in existence 10 years ago. But it found only 58.1 per cent of them had survived in the 10 years to December. The remainder closed or merged, generally because their performance was weak.

If only the surviving funds – which tend to have better numbers – had been included in the overall fund statistics, the total picture would have been unrealistically bright. It would have been like running a horse race in which only 58 per cent of those that started crossed the finish line. If you merely tracked the speed of the finishers, you would be giving an exaggerated picture of the prowess of all those that started the race.

In this case, the researchers tracked the performance of all the original 2,080 funds over one, three, five and 10 years. If a fund didn’t finish, it didn’t beat the market.

The researchers also found that most mutual funds didn’t maintain “style consistency” over 10 years – meaning they changed the investing style they had used when the study began. In fact, only 33.7 per cent of the original funds retained their style, an enormous shift that ought to concern investors, Soe said.

“For investors, style drift can be a very big unexpected risk,” she said.

Why is this significant? Consider a fund that buys stocks like Facebook, those with a high market capitalisation and rapid growth. Such a fund has a large-cap growth style, and investors who hold it might think they have bought a stake in large-cap growth stocks. But then, say, the manager shifts the fund’s holdings to small-cap value stocks.

That may make sense to the manager, who presumably thinks the new stocks will perform better than the old ones, but it can cause a big headache for investors who have built diversified portfolios including this fund. If they know of the shift, they can adjust their holdings, adding cost and possible tax liability. Many people will do nothing and live with unintended risks from a skewed portfolio.

Narrow benchmarks

These problems – long-term underperformance, the demise of many lackluster funds and style drift – showed up in all categories of actively managed domestic stock mutual funds over extended periods. Most of the stock funds in each category underperformed narrow benchmarks over three, five or 10 years. For example, as a group, most small-cap value funds underperformed the S&P SmallCap 600 Value index.

Taken together, the two sets of studies – the tests for performance persistency and the bake-offs – suggest that while it’s possible for fund managers to beat the market, it’s difficult for them do it consistently, especially if their funds have high costs, which drag down returns.

Keith Loggie, the senior director of global research and design at S&P Dow Jones, said: "Fund cost is the most important single factor predicting performance. It makes it harder to beat index funds, which tend to be cheaper."

Some funds do beat the indexes each year. But, costs aside, it's exceedingly difficult to pick the funds that will outperform in the future. Whether investors should even try remains an open question. – Copyright New York Times 2015