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November 25, 2014 at 10:00 AM
The odds of selecting the sort of benchmark-beating mutual funds investors dream of are a slim 1 out of 119, yet investors would not likely stick with them even if they did pick these superstars.
Research Affiliates’ managing director John West and researcher Amie Ko take readers of their November newsletter deep into the institutional manager selection process to show how even the most disciplined professionals, let alone inexperienced consumers, find it difficult to consistently beat the market through active management.
“With these odds, you actually have a slightly better chance of collecting a cash prize on the multi-state Powerball lottery,” West and Ko write.
One might think that the modern age’s wide availability of data would improve our ability to monitor and evaluate manager performance.
For example, “popular software programs can run attributions over custom periods to tell us that our manager added x basis points of stock selection effect in the technology sector,” West and Ko write.
Yet today’s obsession with performance measurement tends rather to undermine investment performance.
That is because the standard three-year windows and quarterly updates that institutional managers conventionally employ do not correspond to the reality that “even the most sterling of long-term track records is pockmarked with performance potholes” of long duration.
Using Burton Malkiel’s definition of a stock mutual fund that genuinely adds value as one that has exceeded the market return by more than 2 percentage points for more than a 40-year period, West and Ko show how unlikely it is to select such a fund in advance.
Of the 358 U.S. equity funds available in 1970, just 30% have survived these past 45 years. Of the survivors, only 45 have outperformed the S&P 500 index.
Of those long-term performers, just three have added valued of 2% or greater excess return, indicating a mere 0.8% chance (1 out of 119) of selecting a superstar manager.
Since even investors satisfied with a star manager (those 45 out of 358 actively managed funds) rather than a superstar have a better than 8 in 10 chance of picking a loser, “it makes considerable sense,” the authors write to monitor their managers’ performance.
But herein lie the pitfalls of contemporary “watch list” policies.
