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Flawed Advice for Picking Mutual Fund 'Winners'

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Don't get me wrong. I am a big fan of Morningstar. The data they provide on investments is in a class by itself. According to its website, Morningstar provides data on more than 385,000 stocks and mutual funds. A lot of the data I use in my blogs (including this one) is derived from software licensed by Morningstar.

So, it was with great interest that I read an article by Shannon Zimmerman, associate director of fund analysis at Morningstar, entitled Passive Success: Index funds are on a roll. Will it persist?

Mr. Zimmerman somewhat grudgingly noted the continued outperformance ("albeit by modest margins") of passively managed domestic-equity index funds through August 6, 2012. He also reported that index funds had significant net inflows in 2012, compared to nearly $50 billion of outflows for actively managed funds. He doesn't put this data in historical perspective. Standard & Poors has no such reluctance. Its latest "scorecard" pulls no punches, stating: "The only consistent data point we have observed over a five year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices."

Undeterred, Mr. Zimmerman makes the case for active management. He correctly notes the importance of investing in funds with low expense ratios and concludes: "Require not only a cheap price tag but also a long-tenured manager who has overachieved during a tenure of 10 years or more and the odds tilt further in the direction of actively managed funds."

His bottom line recommendation is that investors include both "topnotch" actively managed funds and low cost index funds in their portfolios. At first blush, this seems reasonable. Unfortunately, it is not supported by either logic or Morningstar's own data.

If there was a way to identify "topnotch" actively managed funds that were likely to outperform their benchmarks, investors should include only those funds in their portfolios. Regrettably, I am aware of no data indicating anyone has the expertise to make this determination. Looking at past performance is not helpful. One study looked at the performance of the top 100 mutual funds over a thirteen year period from January 1, 1998 until December 31, 2011. It found that about 15 percent of the top managers from one year periods repeated their top 100 performance in the second year.

What about Mr. Zimmerman's advice to consider outperformance over a ten year period? Using Morningstar Direct, I did a search for current active fund managers with 13 years or more of experience. The dates used were July 1, 1999 through June 30, 2012. I then eliminated all managers who did not beat their benchmark by 2 percent or more during the first 10 years of this period (July 1, 1999-June 30, 2009), which left 340 funds in my database. My goal was to determine how investors would have done in the past three years if they had followed Mr. Zimmerman's advice and selected "topnotch" funds that had outperformed their benchmarks in the prior ten year time period. Here's what I found:

Mr. Zimmerman is correct that lower expense ratios have an impact on returns. Funds with expense ratios less than 1 percent for the prior 10 year period had an average "alpha" of 4.64 percent. Very impressive. I can understand why investors would believe these fund managers had figured out how to beat the markets. They would have been very disappointed. In the ensuing three year period, these same funds on average underperformed their benchmarks by 0.53 percent.

The data was worse for active funds with an average expense ratio greater than 1 percent. The average outperformance of these funds was 5.17 percent for the ten year period. In the following three years, average underperformance was 1.19 percent.

The conclusion is inescapable that a 10 year record of stellar performance is not predictive of future performance. Instead of engaging in this exercise, investors would be far better served limiting their portfolios to globally diversified, low-management fee index funds in an appropriate asset allocation.

Clearly, more investors are getting this message, which accounts for the difference in inflows and outflows of index and actively managed funds. Advice to the contrary needs to be supported by hard data, which is rarely the case, even when the advice comes from a highly respected purveyor of this data.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book is The Smartest Money Book You'll Ever Read. The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.