For all their virtues, mutual funds have some serious flaws. To their credit, mutual funds can provide things that most investors desire, things like broad diversification, transparent holdings, good liquidity, and easy trading. Unfortunately, most mutual also have serious performance flaws.
They underperform. The most serious and often discussed problem is that most mutual funds underperform. By underperform, we mean that they fail to match the performance of the market benchmark for that asset class. And by most, we mean the overwhelming majority of funds, roughly 80 percent over ten and fifteen-year periods. The semi-annual report known as SPIVA (S&P Indices versus Active) issued by S&P Dow Jones for the past 15 years has placed this assertion beyond dispute.
For example, over the 15-year period ending June 2017, the results for US stock managers were dismal: 93 percent of large-cap managers, 94 percent of mid-cap managers, and 94 percent of small-cap managers failed to outperform their benchmarks. The results for international stock funds were much the same. Across four categories of international stock funds, the percentage of funds underperforming their benchmark ranged from 83 percent to 95 percent. Across 14 categories of fixed income, the percentage of underperforming funds ranged from a low of 71 percent to a high of 98 percent.
To put a positive spin on it, roughly one out of five managers may outperform their benchmark over ten and fifteen year periods. Those are not great odds, but they are not impossible odds either. In theory, out of a universe of 8,000 funds, there are hundreds of possible winners.
In practice, though, it is exceedingly difficult to pick out the winners in advance. One explanation for that is due to the next problem, good performers are not persistent.
They aren’t persistent. The urge to extrapolate past outcomes into the future, especially about past winners, is a difficult bias to overcome. It is very tempting to try and identify future winners by looking at who has performed well in the past, especially in the very recent past.
Looking to past performance does not work, however, because very few top-performing funds are consistent winners. S&P Dow Jones tracks this in their semi-annual Persistence Scorecard. For example, a recent report looked at the top performing U.S. stock funds as of 2013 and then tracked how well they did over succeeding years. Their findings affirm the dictum that past performance is not indicative of future results. Out of the top 25 percent of managers in 2013, no large-cap managers, mid-cap managers or small-cap managers were able to stay in the top 25 percent by 2017.
It is not simply that the top performers slid a bit and dropped into the next tier. The problem is that their subsequent performance is all over the map. Across all U.S. stock categories, of the top 25 percent at the start of the period, fewer than 25 percent even stayed in the top half a mere four years later. That means that most of the funds dropped into the bottom half of performers or, worse, were liquidated or merged with another fund, usually because of performance shortcomings.
We know from the SPIVA performance data discussed above that a minority of funds will turn out to be good performers over the long run. The problem is that the variability and bumpiness of fund performance along the way makes it difficult to stick with them through all their ups and downs.
Not only is it difficult to identify superior fund managers in advance, it is challenging emotionally for investors to stay loyal to a manager whose performance can vary so much from year to year when measured against their peers and their benchmark. The persistence problem, the fact that few funds can consistently perform at top levels, means that it is nearly impossible for an investor to know that he is invested with a winner.
They drift. Style drift refers to the tendency of some managers to drift away from their stated investment strategy or style of investing. Style drift occurs, for example, when a large-cap manager drifts into mid cap or small cap stocks, or when a U.S. stock manager drifts into international stocks, or when a value manager drifts into growth stocks.
Over relatively short periods, style drift may be barely perceptible, but over longer periods it is a problem. Over a single year, more than 90 percent of funds remain true to their stated investment objective. Over fifteen years, however, well over 50 percent of all U.S. stock funds had drifted into another investment style or objective.
Style drift presents two related problems for investors: it changes their asset allocation and it changes their risk exposure. There is a third problem if investors do not realize that drift is happening. Studies indicate that asset allocation – the amount of exposure to different asset classes – is the single most important factor affecting the portfolio performance realized by the investor. An investor may have targeted a set percentage of U.S. versus international stocks, only to find that style drift by one or more managers has resulted in a very different allocation. Fewer stocks, or more international stocks, or more small-cap stocks than planned can all mean different risk exposures and outcomes than an investor had anticipated.
Mutual funds are a perfectly sound investment vehicle. They will probably remain the preferred investment vehicle for most investors for years to come. But investors need to constantly monitor their selections to be sure that they are getting what they paid for.
This article appeared in the February 15th, 2018 issue of The Daily Record. Download a PDF copy.