On January 3rd, the Wall Street Journal ran an article titled, Investors Sour on Pro Stock Pickers. Author Kristen Grind noted that investors are jumping out of mutual funds managed by professional stock pickers and shifting massive amounts of money into lower cost funds that echo broader markets. $7.5 billion flowed out of equity mutual funds in November alone, and after December is tabulated, 2012 will be the largest outflow since 2008. By the end of November, almost $120 billion flowed out of equity funds, PLUS an additional $628 million flowed into bear-market funds and a similar amount into Long/Short funds. According to Morningstar, the largest outflows have been from Large Cap Growth funds, followed by Large Cap Value funds.
Some of the flows are tactical asset allocations, and some are changes in attitudes about the value that mutual fund managers bring to the table. While a majority of the outflows are being reinvested in bond funds, some of these equity funds are being redirected into ETFs, and even other into direct equity investments. Grind notes, accurately, “the mission of stock pickers in a managed mutual fund is to outperform the overall market by actively trading individual stocks or bonds, with fund managers receiving higher fees for their effort.” However, that is not what is happening.
Merrill Lynch released a report yesterday noting that in 2012, “39% of managers beat the S&P 500. Value and Core managers achieved 21% and 38% success rates, respectively. 54% of Growth managers outperformed the benchmark.” It was a tough year to beat the S&P, as certain of its components performed uniquely better than many “average” companies. For instance, Apple (AAPL) is the largest capitalized name in the S&P, and since the S&P is a market cap weighted index, it has the most influence. Rather than having a 1/500th influence on the price, at its peak, Apple represented 4.5% of the index. But it’s not just Apple. The Value Line geometric index underperformed the S&P 500 by more than 500 basis points.
That said, underperforming the S&P is not uncommon. Last Febuary, Beth Braverman of Money Magazine reported that “79% of large-cap fund managers trailed the Standard & Poor’s 500-stock index, says Morningstar — the worst showing since 1997.” Part of it is expenses. The average fund expense for mutual funds is 1.44% – and that includes low-fee index replacement options. The true cost of actively managed funds is over 2%, plus the addition of 12b-1 fees and other administrative expenses and trading costs. Using history as a guide, the percent of active managers that beat the S&P is less than 50%.
Additionally, those that DO actually beat the S&P, don’t do it with consistency. The ability of long-only managers beating the index consistently has been debunked in research. Additionally, out-performance by active managers often comes when a particular strategy has underperformed in general, or when managers participate in style drift.
Rick Ferri of Forbes writes an interesting observation here:
Active funds perform well when a style is out of favor. On average, about two-thirds of active funds beat index funds in the style with the worst short-term performance record. This occurs because the active managers are not style pure in their fund selections. Being messy boosts fund performance when the core style performs poorly. This is when active funds tend to outperform comparable index funds.
William Thatcher of Mercer Hammond has been quantifying Dunn’s Law for several years. He calls it the purity hypothesis. Thatcher first published research on this phenomenon in 2009 in the Journal of Investing and recently updated his findings in 2012 in The Journal of Index Investing.
Thatcher studied the purity hypothesis over 150 independent time periods and across three index providers: MSCI, Russell and S&P. He found a 0.88 correlation between how well a style performed and how well active managers in that style performed relative to a comparable style index.
Experienced fishermen know that fish tend to congregate in one section of a lake. The challenge is to figure out where that section is. The purity hypothesis challenges active investors in the same way. If you can figure out which investment style will deliver the worst performance, you have a high probability of picking a winning actively-managed fund in that style.
This all sounds interesting, and perhaps some people can use this information to pick a winning manager, but let’s not forget one important fact. We invest to earn money. Why would you invest any money in a losing style if you’re skilled at picking them?
We speak it ad naseum, but our suggestion is to build your own investment strategy that meets your risk and return parameters. You can do it better and for lower cost.