aswath_damodaran-investment_philosophies_2012

Source: B. G. Malkiel, “Returns from Investing in Equity Mutual Funds 1971 to 1991,” Journal of Finance 50 (1995): 549–572.

funds that earn above-average returns in one period will continue to earn above-average returns in the next period.

Malkiel tested for this “hot hands” phenomenon by looking at the percentage of winners each year who repeated the next year in the 1970s and 1980s.33 His results are summarized in Table 13.5.

N U M B E R W A T C H

Best-performing mutual funds: Take a look at best-performing mutual funds over the past year.

Table 13.5 tells a surprising story. The percentage of repeat winners clearly is much higher than dictated by chance (50 percent) in the 1970s. However, the percentage of repeat winners during the 1980s looks close to random. Is this because mutual fund rankings became more ubiquitous during the 1980s? Maybe. It is also possible that what you are seeing are the

33B. G. Malkiel, “Returns from Investing in Equity Mutual Funds 1971 to 1991,” Journal of Finance 50 (1995): 549–572.

Decile Based on Excess Return in Prior Period

F I G U R E 1 3 . 1 3 Persistence in Mutual Fund Performance, 1999 to 2008

Source: E. J. Elton, M. J. Gruber, and C. R. Blake, “Does Size Matter? The Relationship between Size and Peformance” (SSRN Working Paper 1826406, 2011).

effects of overall market performance. In the 1970s, when the equity markets had a string of negative years, mutual funds that held more cash consistently moved to the top of the rankings. Malkiel also compares the returns you would have earned on a strategy of buying the top funds (looking at the top 10, top 20, top 30, and top 40 funds) from each year and holding it for the next year. Again, the contrast is striking. While the top funds outperformed the S&P 500 in the 1973–1977 and 1978–1981 time periods, they matched the index from 1982 to 1986 and underperformed the index from 1987 to 1991.

So, does the hot hands phenomenon continue to hold? If yes, why does it persist? Elton, Gruber, and Blake look at all mutual funds from 1999 to 2009, and document that the funds that have done well in the past continue to do well in the future and those that have done badly continue to do badly, as evidenced in Figure 13.13. This study also finds that the top-performing funds decrease fees (rather than increase them) and the fees increase at the worst-performing funds, and that there is no relationship between fund size and persistence. In other words, persistence in performance is just as strong with large funds as with small ones.34 As to why it persists, they

34E. J. Elton, M. J. Gruber, and C. R. Blake, “Does Size Matter? The Relationship between Size and Peformance” (SSRN Working Papers 1826406, 2011).

offer several hypotheses: that large funds may hire the best analysts and that they are able to control a larger share of the resources of the fund family, as well as get first access to the investment opportunities that the fund family discovers.

Luck or Skill? Even the most pessimistic assessments of mutual funds conclude that some of them have delivered high excess returns over extended periods. The question then becomes whether this performance should be attributed to the skills of the managers of these funds or to luck. To answer this question, Fama and French took a novel tack by running simulations of mutual fund performance using histories of individual fund returns from 1984 to 2006 as the raw data, setting the average excess return to zero, and comparing the distribution of the excess returns generated for the simulated funds with the distribution of actual excess returns across funds. On a net return basis, they could not reject the hypothesis that the excess returns earned by some mutual fund managers can be entirely attributed to luck and that the average mutual fund manager underperforms by the amount of management expenses. On a gross return basis, the average mutual fund manager breaks even with the market.35

I n S u m m a r y

Looking at the evidence on mutual fund performance, we find that the average mutual fund underperforms the market, and this underperformance cannot be explained away by critiquing the risk and return models used by researchers. The underperformance is also pervasive and seems to affect funds in every style category. It also gets worse for funds that have up-front loads and higher expense ratios. In fact, the only mildly positive result is that growth funds do less badly against their indexes than value funds do against their indexes.

If the argument being mounted by active money managers is that we should focus on the winners, the results reveal a disconnect. While the probability that funds that have been successful in the past will continue to remain so in the future is low, the most successful mutual funds in the past period, on average, deliver much better risk-adjusted returns in the next period than the least successful ones. In fact, there are lots of reasons to avoid the worst-performing funds. Not only are they more likely to continue

35E. F. Fama and K. R. French, “Luck versus Skill in the Cross Section of Mutual Fund Returns,” Journal of Finance 65 (2010): 1915–1947.

Total Return Excess Return

F I G U R E 1 3 . 1 5 Turnover Ratios and Returns: Mutual Funds

Source: J. M. R. Chalmers, R. M. Edelen, and G. B. Kadlec, “An Analysis of Mutual Fund Trading Costs” (SSRN Working Paper 195849, 1999).

In fact, Chalmers, Edelen, and Kadlec find that the relationship between turnover and excess returns is fairly weak, as evidenced in Figure 13.15.36

Note that while the funds with low turnover have slightly less negative excess returns than funds with high turnover, they also earn lower total returns. When the study looked at the relationship between total costs (including trading costs and other expenses), the results are much stronger (see Figure 13.16).

Funds with higher total costs have much lower total returns and much more negative expense ratios than funds with lower total costs.

H i g h T a x e s

In Chapter 6, we considered the interrelationship between taxes and transaction costs. Mutual funds that trade a lot also create much larger tax bills for their investors and this can best seen by contrasting the pretax and after-tax returns at funds. In Figure 13.17, we consider the difference between pretax

36J. M. R. Chalmers, R. M. Edelen, and G. B. Kadlec, “An Analysis of Mutual Fund Trading Costs” (SSRN Working Paper 195849, 1999).

F I G U R E 1 3 . 1 6 Trading Costs and Returns: Mutual Funds

Source: J. M. R. Chalmers, R. M. Edelen, and G. B. Kadlec, “An Analysis of Mutual Fund Trading Costs” (SSRN Working Paper 195849, 1999).

F I G U R E 1 3 . 1 7 Tax Effects at Index and Actively Managed Funds Source: Morningstar.

and after-tax returns at the five largest index funds and contrast them with pretax and after-tax returns at the 10 largest actively managed funds.

Note that the after-tax return at an active fund is almost 20 percent lower than the pretax return. In contrast, the difference between pretax and after-tax returns is much smaller at index funds.

T o o M u c h A c t i v i t y

We invest in actively managed funds because we want them to be actively seeking out undervalued stocks. But does this activity pay off? In the study by Lakonishok, Shleifer, and Vishny that looked at pension funds, they contrasted the return that funds would have made if they had frozen their portfolios at the beginning of each year with the return that they actually made, after trading through the year. You can consider the difference between the returns as the payoff to active money management and Figure 13.18 presents the results for funds in different style classes.

The results indicate that far from adding value, activity reduces returns by between 0.5 percent (for yield funds) to 1.4 percent (for other funds). In other words, these funds would have done better if they had sent everyone home at the start of the year and not traded over the course of the year.

F I G U R E 1 3 . 1 8 Payoff to Active Money Management

Source: J. Lakonishok, A. Shleifer, and R. Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance 49 (1994): 1541–1578.

Chen, Jegadeesh, and Wermers paint a more favorable picture of the stock-picking skills of mutual fund managers.37 While they find no evidence that stocks that are widely held by mutual funds do any better than other stocks, they do find that stocks that are bought by mutual funds earn higher returns in subsequent periods than stocks that are sold. They also conclude that growth-oriented funds have better stock-selection skills than funds in other categories.

F a i l u r e t o S t a y F u l l y I n v e s t e d i n

E q u i t i e s — D e l u s i o n s o f M a r k e t T i m i n g

Actively managed funds often hold far more cash than they need to meet normal needs, and these cash holdings often reflect the market timing views of managers, increasing when managers are bearish and decreasing when they are bullish. As a consequence, mutual funds will tend to underperform the equity index in periods when the equity index increases by more than the riskless rate. Active money managers concede this drain on returns, but argue that their investors are more than compensated by the payoff from market timing. In particular, mutual fund managers contend that they keep investors out of bear markets and thus reduce their downside. In Figure 13.19, we compare the performance of actively managed funds and the S&P 500 in six market downturns.

The results don’t indicate much market timing ability, since active funds did even worse than the S&P 500 in four of the six downturns. There is another cost, as well. Active money managers often seem to shift into cash during bear markets and they tend to stay in cash too long. Looking at the returns on active funds and the index in three bear markets in the 1970s and 1980s and in the 12 months after each bear market, we find that whatever additional returns may have been earned by active funds during the bear market are effectively wiped out in the 12 months following. In summary, then, the cash holdings of active money managers seem to cost them more in opportunities lost than any potential gain from market timing.

B e h a v i o r a l F a c t o r s

There are three other aspects of mutual fund behavior that seem to contribute to their poor performance. One is the lack of consistency when it comes

37J. L. Chen, N. Jegadeesh, and R. Wermers, “The Value of Active Mutual Fund Management: An Examination of the Stockholdings and Trades of Fund Managers,”

Journal of Financial and Quantitative Analysis 35 (2000): 343–368.