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Why Is an Investment in Mutual Funds a Bad Idea?

All about investments, personal finance and well-being! But almost always based on academic research.

In this article we will focus on analyzing those actively managed mutual funds, that is, the vast majority, in order to conclude whether or not they are a good investment alternative. All this based on academic studies.

For those who don't know, a mutual fund is a company that pools money from many investors and invests it in stocks, bonds, and other securities. Many times that money is managed by an administrator (or a group of administrators) who have the task of choosing the best assets, sectors and countries in which to invest the clients' money. The ultimate goal is that, with the help of the superior skill and knowledge of these managers, the mutual fund will generate a higher return than the market in which it is invested.

With the above, we can conclude that, in order to define whether or not active management mutual funds are a good investment alternative, we have to define whether, firstly, there are managers with superior skills and, secondly, analyze whether this skill is maintained or improved in the long term. Let's evaluate both edges.

The skill of active managers

The paper "On persistence in mutual fund performance" by Mark M. Carhart in 1997 analyzed 1892 US mutual funds between 1962 and 1993, his main conclusion was that there is no evidence of the presence of superior skill in asset selection or timing the market by mutual fund managers. In addition, the results indicate that, on average, mutual funds are not able to recover their costs thanks to higher returns. Additionally, these costs are negatively related to the fund's results.

A somewhat different result (although along the same lines) was obtained by the paper "Luck versus Skill in the Cross-Section of Mutual Fund Returns" by Eugene Fama and Kenneth French from 2010. This paper concluded that the aggregate of mutual funds obtain returns below its benchmarking. The vast majority of mutual funds fail to cover their costs and, if such funds do exist, they are extremely rare and impractical to find.

When analyzing in the long term, the previous authors were able to conclude that the portfolio of the aggregate of mutual funds is very close to that of the market, thus producing an "alpha" (before costs), that is, excess return over the market, close to 0. However, after costs, the investor receives a negative alpha.

As we can see, there are practically no mutual fund managers who can justify their high costs and, if they do exist, they are extremely rare and hidden in the huge mass of managers who, by sheer luck, get good returns in the short term.

Now we have to evaluate another point. Can the best mutual funds maintain their returns over the long term?

The returns in the long run

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Chance and luck play a fundamental role in the world of investments. The first paper that I mentioned in this article aimed to study whether or not mutual fund returns are maintained in the long term. One of its conclusions is that luck is an important factor when analyzing mutual fund returns. This is demonstrated when it comes to seeing that the best funds in a given year do not have better chances of continuing to be so the following year.

It was found that the most successful funds in a given year tend to be the worst performers the following year. Specifically, of all the funds studied, the 10% with the best returns in a given year only have a 17% chance of continuing to hold that position for the next 5 years. This supports the idea that abnormal results are due to luck and not skill.

For their part, funds that perform poorly in a given year should be avoided, as there is a high probability that they will continue to do so in the future. Specifically, it was found that, of the funds studied, the 10% with the worst results in a given year have a 46% chance of remaining in that classification or disappearing in a period of 5 years.

Even by sheer luck and chance, you can outperform the market for many years (we're talking more than a decade). Examples of these events abound:

  • In the 1970s David Baker's “44 Wall Street” fund outperformed the market for 10 years. In the following decade, it was the worst-performing fund in its category.
  • The “Lindner Large Cap” fund beat the market for 11 consecutive years until 1984. The fund spent the next 18 years being torn apart by market returns (in this case S&P 500).
  • Bill Miller, fund manager "Legg Mason Value Trust" beat the market for 15 years until 2005. For the next 7 years it suffered dismal results until it was acquired by a new manager in 2012.
  • The "Tiger Fund", a fund formed in 1980 spent 18 years with an average return of 30% per year. After 1998 the fund lost so much that half of its investors walked out within a year and it finally closed its doors in 2000.
  • A more current case could be what happened with Cathie Wood's "Ark Invest" fund, a fund that had amazing returns in 2020, but lost so much in 2021 that, by the end of that year, the index against which they were competing had surpassed them.

As we can see, mutual funds that outperform the market for many years is not proof of the existence of managers with superior skill. Moreover, events like these are totally expected by chance. However, these results do not persist in the long term.

In case you're thinking about it: trying to guess or predict which mutual funds will be those are great returns and, in addition, predicting when to get out, is a strategy that will give you quite a lot of losses in the long run. I invite you to read my article on Market Timing to have more information on the subject.

Summary

To conclude, almost all (if not all) of the academic information on the returns of actively managed mutual funds points to the same conclusion: They are not a good investment alternative. There is almost no evidence of skilled managers, and furthermore, those funds with good returns are unlikely to maintain those returns. By sheer chance, some may outperform the market for years (well over 10 years), but sooner or later those returns fall below the index against which they compete (and this without considering their costs).

I hope you liked it and that my article is useful to you. Stay tuned as I will be analyzing other investment alternatives over time. But all from an academic perspective.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2022 Nicolas Hidalgo

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