What are an investor’s chances of reaping abnormal returns from mutual funds? Is it possible to identify the funds that will outperform? In their December 2006 paper entitled “Mutual Fund Performance”, Keith Cuthbertson, Dirk Nitzsche and Niall O’Sullivan address these questions via review of past academic research on US and UK managed mutual funds, with focus on studies done within the last 20 years. They conclude that:
- On average, both index mutual funds (by roughly the total expense ratio) and actively managed mutual funds underperform appropriate benchmarks after fees. Only 2-5% of equity mutual funds show truly skillful net outperformance. However, 20-40% of funds exhibit clear (worse than bad luck) net underperformance.
- The drivers of relative performance among mutual funds are mostly load fees and expenses and, to a lesser extent, portfolio turnover. There is little evidence of successful market timing by mutual funds.
- Mutual fund outperformance does persist, most noticeably for periods of one year or less. However, economic gains to investors who actively rebalance into winner funds may be marginal because of transactions costs and fund fees. Sophisticated (such as Bayesian) sorting rules may enable substantial gains from rebalancing into winners monthly.
- Past loser funds clearly tend to continue underperforming for several years.
- Results for bond mutual funds are generally similar to those for equity mutual funds.
- Hedge funds show better risk-adjusted performance than do mutual funds, and stronger persistence of outperformance.
- Overall, results suggest that the typical investor should hold low-cost index funds and especially avoid actively managed funds with poor past performance. Only very sophisticated investors should consider an active mutual fund switching strategy.
In introductory sections, this paper provides an overview of mutual fund industry structure and performance measurement in the US and UK.
In summary, this review of mutual fund studies makes low-cost, broad market exchange traded funds sound good.
Frequently Asked Questions
What is mutual fund performance persistence and why does it matter to investors?
Mutual fund performance persistence is the tendency of funds that outperform (or underperform) benchmarks in one period to keep doing so in later periods. A review of US and UK studies by Cuthbertson, Nitzsche and O'Sullivan finds outperformance does persist, most noticeably over periods of one year or less. Past loser funds clearly tend to keep underperforming for several years.
Do actively managed mutual funds beat the market after fees?
Actively managed mutual funds do not beat appropriate benchmarks on average after fees, according to a 2006 review of US and UK studies from roughly the prior 20 years. Only 2-5% of equity mutual funds show truly skillful net outperformance, while 20-40% show clear net underperformance that is worse than bad luck. Index funds also trail benchmarks, but only by roughly their total expense ratio.
How do researchers separate mutual fund manager skill from luck?
Researchers separate mutual fund skill from luck by testing whether a fund's net performance versus appropriate benchmarks is better or worse than chance alone would produce. The review of US and UK equity fund studies finds only 2-5% of funds show skillful net outperformance, while 20-40% show underperformance worse than bad luck. Studies also examine drivers of relative performance, which are mostly load fees and expenses and, to a lesser extent, portfolio turnover.
How do hedge funds compare to mutual funds in risk-adjusted performance?
Hedge funds show better risk-adjusted performance than mutual funds, according to the review of academic studies. They also show stronger persistence of outperformance. Results for bond mutual funds are generally similar to those for equity mutual funds.
Can investors profit by switching into past winning mutual funds?
Switching into past winning mutual funds may yield only marginal economic gains for investors because of transactions costs and fund fees, even though outperformance persists over short periods. Sophisticated sorting rules, such as Bayesian methods, may enable substantial gains from rebalancing into winners monthly. The review concludes that only very sophisticated investors should consider an active fund-switching strategy, and that typical investors should hold low-cost index funds.