Wednesday, 4 December 2013

Mutual Funds: An empirical study

The purpose of actively managed funds is to outperform the broad market index by exploiting informational gaps to identify any undervalued or overvalued stocks. A seemingly contradiction to the Efficient Market Hypothesis proposed by Eugene Fama in the 1960s who argued that it is impossible to beat the market because the stock market is efficient and all information are reflected by the stock price. Of course, theoretical hypothesis seldom model what we observe perfectly. In reality, market inefficiencies exist. Investors are influenced by many psychological factors which cause the prices to deviate from their intrinsic value. But how successful were the fund managers in exploiting these inefficiencies? To answer the question, several studies on the (relative) performance of actively managed funds were conducted. The following quotation summarizes their findings:

  • "Eugene Fama, William Sharpe and Jack Terynor were some of the first researchers to note the apparent lack of skills by mutual fund managers."
  • "Economist Michael Jenson provided his view in 1967… there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance ."
  • "Carhart (1997) observed that although some mutual funds outperform, on average, mutual fund managers did not exhibit superior investment skills.” 

This blog entry will highlight some of the findings in a more recent study conducted by Ferri and Benke, which investigated the probability that an index fund outperforming actively managed funds. Unlike previous studies, Ferri and Benke had taken precaution against survivorship-bias in actively managed fund which tend to positively skew their performance. Several restrictions were also introduced to the study which penalizes the performance of index funds, including the omission of front or back-end loading from actively managed funds, index funds with highest expense ratio was used when two or more share classes of the fund existed and pretax performance was used (index funds tend to have better tax efficiency). 

Findings # 1
Index funds have a higher probability of outperforming actively managed funds when combined together in a portfolio.
Based on the fund performance between 1997 and 2013, three-fund index fund portfolio has a probability of 82.9% in winning a comparable actively managed fund in term of returns. It is also worth noting that among those which outperformed the index fund, the median excess return is only 0.52%, compared to the median excess return of -1.25% of the underperformers. Probabilistically, it does not pay to invest in actively managed funds.
Figure 1 illustrates the result. The excess returns of actively managed funds were arranged from worse to best. Returns below 0 indicate that the index fund had performed better than the particular actively managed fund and vice versa. 

Findings # 2
The probability of index fund portfolio outperformance increased when the time period was extended from 5 years to 15 years
Given the difficulty to beat the index fund, perhaps it is not surprising that the longer the investment period, the harder it is for an active fund to continuously beat the market. Ferri and Benke study goes on to show that this hypothesis is supported empirical results. On average, the index fund outperforms the active fund 76.5% of the time in a 5 year period and 83.4% in a 15 year period.

Findings # 3
The probability of index fund portfolio outperformance increased when 2 or more actively managed funds held in each asset class
A surprising finding in the study is that diversification within asset class in actively managed funds actually hurt the investor. When each asset class is diversified into 2 or 3 active funds, the probability of index fund winning increases to 87.1% and 91% respectively, compared to 82.9% when there is no diversification.  

Findings # 4
Fees affect performance only to a small degree.
A major criticism of actively managed fund is the high fees and charges payable by the investors. It includes one off charges such as front-end load, back-end load which ranges from 1% to 5% and switching fees which are typically around 0.5% to 1%. In addition, there are also recurring fees, known as Total Expense Ratio (TER), which are payable annually, such as the management fees, trustee fees and miscellaneous fees which range from 0.5% to 2%. All these charges/fees can reduce the returns of your investment substantially. However, based on the empirical results of Ferri and Benke study, the effect of fees on fund performance is not significant. Although, it should be noted that one-off charges are omitted in the study.

The findings presented overwhelming evidence against actively managed funds. While the findings certainly do not preclude the possibility that any particular actively managed fund will outperform the index fund at a given point in time, predicting the ‘correct’ fund is highly unlikely and even less so with a long time horizon. Investors, especially the less sophisticated, might have a higher chance of realizing their investment goals using the simple index fund strategy. 

For those who are keen, the original report is available here: A Case for Index Fund Portfolios.

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