5.2.1 Manager Ratings

Since more than 95% of mutual funds are actively managed, the various mutual fund ratings exist primarily for manager pickers. However, a recent review of these ratings show a wide variation in rating methods and results. For example, the same four funds were rated according to four different publications. Table 5-1 reveals the results.

Table 5-1

On this table, funds A, B, C, and D are actual mutual funds. They are not identified because the purpose of this illustration is not to sell a particular security. It is to emphasize that ratings, in and of themselves, do not provide enough information for making an investment decision.

These systems measure criteria about managers that is about as useful as a tipster giving advice at the race track. To make matters worse, there are countless stockbrokers, money managers, hedge fund managers, investment advisors, private money managers, and newsletter publishers, who do not operate publicly traded mutual funds. They are not required to report the same detailed information that is required of mutual fund managers. These managers are often criticized for the smoke and mirrors they have created to mask their results.

Luckily, investors received a gift from the SEC that blew away some of the smoke. In 2001 the SEC adopted a rule that requires mutual funds to disclose after-tax returns in their prospectuses. This requirement equipped investors with a more accurate report on returns.
The ruling also helped open the eyes of investors, especially those using actively managed funds in taxable accounts.

5.3.1 Past Performance is No Guarantee of Future Results

Unlike the 20-year characteristic of an index, the past performance of money managers has no bearing on their future performance. Every reputable study of mutual fund performance over the past 30 years has found there is no reliable way to know if past superior managers will win again in the future. This is why some variation of the disclaimer “past performance is no guarantee of future results” must appear in all mutual fund advertisements and prospectuses, even though the SEC allows it to be written in very small print.

Studies show that those who have outperformed some past benchmark are more likely to underperform it in the future. Burton Malkiel, author of the long-time investment best seller, A Random Walk Down Wall Street, conducted a study in 1995. In the study’s conclusion, he states, “It does not appear that one can fashion a dependable strategy of generating excess returns based on a belief that long-run mutual fund returns are persistent.”

Investment experts give several reasons why past performance is no guarantee of future results. The most frequently cited is that any outstanding track record turned in by a money manager is the result of the market favoring his particular investment style. One implication of this is that any such performance is entirely unpredictable—as is the time period that such good fortune may or may not last. Since market returns are correlated to risk factors (not to managers), there is no reason to expect that one manager will do better than another.

In addition, outstanding performance is often achieved when a mutual fund is small. This performance usually fuels an exponential growth in the amount of money that must be invested by the fund. The trading and other costs generated by the investment of this much larger amount of money can neutralize or even outweigh the margin by which a mutual fund manager may beat the market in the future.

Numerous studies have shown that actively managed investments generally carry more risk and lower returns than globally diversified, risk-calibrated index portfolios. Despite this fact, governing boards of retirement plans, foundations and endowments frequently fall prey to manager picking consultants and the allure of past winners, hiring the hottest new fund managers only to fire them later because their past performance doesn’t persist in the subsequent periods. A recent study conducted by Amit Goyal of Emory University and Sunil Wahal of Arizona State University found that manager hiring and firing decisions made by consultants and board members of retirement plans, endowments, and foundations was a complete waste of money and the board members precious time. "The Selection and Termination of Investment Management Firms by Plan Sponsors" reveals the negative impact of manager chasing. The results, as set forth in the figure below, demonstrate that during the ten-year period from 1994 through 2003, consultants and boards which based their fund manager hiring decisions on consistent above benchmark past performance were largely disappointed with subsequent index-like results. They often then fired their managers in favor of another recent top performer, repeating the cycle again. This cyclical motion undermines their investment policy statements and the opportunity of achieving optimal returns, the kind of returns that are available by simply buying, holding and rebalancing a passively managed portfolio of index funds that keeps costs low and controls risk.

The Abstract from The Selection and Termination of Investment Management Firms by Plan Sponsors

"We examine the selection and termination of investment management firms by plan sponsors (public and corporate pension plans, unions, foundations, and endowments). We build a unique dataset that comprises hiring and firing decisions by approximately 3,700 plan sponsors over a 10-year period from 1994 to 2003. Our data represent the
allocation of over $737 billion in mandates to hired investment managers and the withdrawal of $117 billion from fired investment managers. Plan sponsors hire investment managers after large positive excess returns up to three years prior to hiring. However, this return chasing behavior does not deliver positive excess returns thereafter;
post-hiring excess returns are indistinguishable from zero. Plan sponsors terminate investment managers after underperformance, but the excess returns of these managers after being fired are frequently positive. Using a matched sample of firing and hiring decisions, we find that if plan sponsors had stayed with fired investment managers, their
excess returns would be larger than those actually delivered by newly hired managers."

Figure 5-A

Figure 5-B

In November 2007, two actual hiring decisions at a foundation were analyzed to verify the above findings. As seen by the two charts below, the study of 8,755 hirings matched the live results of two managers at the foundation.

Figure 5-C

Figure 5-D

Figure 5-E

Figure 5-F

Figure 5-G

Figure 5-H

In reference to Figures 5-I and 5-J: Plan sponsors terminate investment managers after underperformance, but the excess returns of these managers after being fired are frequently positive. Using a matched sample of firing and hiring decisions, we find that if plan sponsors had stayed with fired investment managers, their excess returns would be larger than those actually delivered by newly hired managers.

Figure 5-I

Figure 5-J

Figure 5-K

In further support of this underperformance of institutions, take a look at these charts from the National Association of College and University Business Officers (NACUBO), which is an organization with membership totaling more than 2,500 U.S. colleges and universities. In part, NACUBO provides comprehensive annual data that reports on the financial status of university endowments, and is the industry standard for such information.

The four charts below show 1, 3, 5 and 10 year comparisons for the average nominal rates of returns for various levels of asset pools versus comparable IFA Index Portfolios. The specific IFA Index Portfolios were selected based on the average asset allocations of equities and fixed income/cash equivalents, as provided by NACUBO. For each of the time periods shown, and at all asset levels, the comparable Index Portfolios outperformed the average endowment's return. This demonstrates that IFA has a better set of benchmarks than those probably used by these institutions. Additionally, the Index Portfolios' returns were derived through global diversification, risk and return optimization, investment transparency and no use of speculation or leverage.

The passive rebalancing of index portfolios is a very low cost and low maintenance investment strategy that minimizes need for inhouse investment staff, board member involvement, consultant involvement and the time consuming, useless and costly process of manager selection and terminination.

Figure 5-L

Figure 5-M

Figure 5-N

Figure 5-O

Figure 5-P

Figure 5-Q


From the Discussion at the end of The Selection and Termination of Investment Management Firms by Plan Sponsors: "How does one interpret this evidence? One way to think about this is in terms of opportunity costs and frictions. For hiring decisions that are necessitated by the termination of an existing investment manager (due to performance, organizational or reallocation reasons), the opportunity costs of hiring can be identified as the returns that the fired manager would have delivered relative to what the hired manager actually delivers. Our round-trip results suggest that these opportunity costs are positive."

And from the Conclusion: "In this paper, we examine the selection and termination of investment managers by plan sponsors. To do so, we build a dataset that comprises hiring and firing decisions by 3,600 plan sponsors over a 10-year period from 1994 to 2003. We find that plan sponsors hire investment managers after these managers earn significant excess returns. Post-hiring returns, however, are statistically indistinguishable from zero [IFA inserted comment: after management fees and transistion costs they are decidedly negative]. In contrast, plan sponsors terminate investment managers after poor performance but the performance of these investment managers appears to rebound after firing. We also examine a set of round-trip firing and hiring decisions and find that the post-firing returns of fired investment managers are generally larger than the post-hiring returns of hired investment managers. Given the magnitude of the return differences, and the transactions costs associated with transitioning portfolios from fired investment managers (legacy portfolios) to hired nvestment managers (target portfolios), our results suggest that the termination and selection of investment managers is a costly endeavor."

Active managers have often told me that academics don't see the real world from their ivory towers, but it appears that they do a better predictor of outcomes than the manager pickers who selected these managers.

This data are all that is needed to prove that manager picking doesn’t work and is not a good basis on which to invest money. But there is more for the Doubting Thomas' among you.

5.3.2 Persistence in Track Records

Once again you can see that manager picking is virtually impossible. As Bob Dylan said in the last verse of his tune, “The Times they are a Changin,” “the first one now will later be last, for the times they are a changin’.”

There happens to be one correlation between the past and the future, which seems to ring true for some mutual funds. Past poor performance tends to persist in the future, primarily because of the high costs charged by many funds. A 1996 study by Mark Carhart concluded, “Persistence in mutual fund performance does not reflect superior stock picking skill. Rather, common factors in stock returns and persistent differences in mutual fund expenses and transaction costs explain almost all of the predictability in mutual fund returns. While the popular press will no doubt continue to glamorize the best performing mutual fund managers, the mundane explanations of strategy and investment costs account for almost all of the important predictability in mutual fund returns.”

Any predictability in performance has little to do with the stock picking skills of a specific mutual fund manager. A better way to determine which funds will do better over the long run is to find those that have captured the appropriate risk factors, are low cost, and generate minimal taxes. Index mutual funds fit these criteria very well.



An analysis of the Morningstar database of 800 domestic equity funds with 10 years of returns is shown in Figure 5-2. The top graph shows the rankings of 800 managers from best to worst for the first five year period from 1991 to 1995, and then maintains the first period ranking for the subsequent five years, from 1996 to 2000, to see if manager performance persisted. It came as no surprise to the researchers that what appears to be a sorting of skilled and unskilled managers in the first period turns into randomness in the subsequent period. The second study shown in Figures 5-3 looks at another five-year period from 1995 to 1999. The second period of 2000 to 2004 also shows total randomness of manager performance. Figure 5-4 is a similar analysis, but for three-year periods and only 100 managers so the lines are more visible. As can be seen, there is no useful information in three-year returns either. Whether it is five-year or three-year track records, the conclusion is the same: managers’ track records of returns are of no value to manager pickers.

Figure 5-2

Figure 5-3

Figure 5-4

The top 30 mutual funds for sequential five-year periods from 1971 to 2002 are charted in Table 5-2 (left column), along with the performance of each period’s same top 30 funds for the subsequent period up to 1998 (right column). In each case, the so-called “great 30 funds” did worse than the S&P 500 in subsequent years. This is further proof that the funds’ great performance for a five-year period is not caused by skill, but by luck. If it were skill, it would continue in the future.

Table 5-2 Figure 5-5

An investment strategy that focuses on investing in index funds using an asset allocation method does not require chasing the recent performance of a particular money manager or index because that index is already known to be a winner over the long term.

Seventy-five percent of mutual fund inflows typically follow the previous year’s “winners,” usually based on the Morningstar Rating for funds. As already stated, a Dalbar study concluded that the average investor holds a mutual fund for 4.2 years. The result of this short-term holding pattern is a phenomenon called “investor whipsaw.”

Please look forward for Tables 5-3 through 5-15. These tables provide an interesting analysis of managers’ performance over time. They track the rankings of the top 10 mutual funds from one year into future years. The total number of mutual funds for each year is listed at the bottom of each column. The managers are tracked up to 2004 to see how those “great funds” from the first years did in subsequent periods. The total number of mutual funds for each year is listed at the bottom of each column. The managers are tracked up to 2006 to see how those "great funds" from the first years did in subsequent periods. The results are similar, whether looking at all funds or one asset class. Tables 5-13 through 5-15 show the top ten managers of specific asset classes and their subsequent performance. As the tables show, those funds that were the winners in one year performed poorly in subsequent years. For the top ten managers from 1996 (Table 5-12), the highest ranked from that group fell to 4,695 out of 6,348 in 2006. And the number eight performer from 1996 came in at 5,330 out of 6,348, and was outperformed by 84% of his peers--quite a tumble indeed.

Figure 5-5 illustrates how investors can get whipsawed after buying a top fund. It lists the top 10 mutual funds in 1991, then tracks them by decile rankings through 2001. A 100th percentile rank means that those funds performed in the top one-hundredth of all funds that year. Note continued randomness of future percentile rankings. After wildly bouncing around, eight of the 10 funds ended up in the lower 50th percentile at the end of the 10 years. The other two landed in the lower 60th percentile. The long-term performance of each fund was neither consistently good nor consistently poor.

Table 5-3

Table 5-4

Table 5-5

Table 5-6

Table 5-7

Table 5-8

Table 5-9

Table 5-10

Table 5-11

Table 5-12

Table 5-13

Table 5-14

If you track the top ten performers in each period, you will see that almost every one eventually drops to the bottom of the pack. Once again, you can see that manager picking, performance chasing or track record investing is virtually impossible and a complete waste of your time and money.

As Bob Dylan stated in the The Times They are a Changin':
For the wheel's still in spin, and there's no tellin' who that it's namin'
For the loser now, will be later to win
The first one now, will later be last.
For the times they are a-changin'.

Verse 2: Come writers and critics Who prophesize with your pen And keep your eyes wide The chance won't come again And don't speak too soon For the wheel's still in spin And there's no tellin' who That it's namin'. For the loser now Will be later to win For the times they are a-changin'.

Verse 5: The line it is drawn The curse it is cast The slow one now Will later be fast As the present now Will later be past The order is Rapidly fadin'. And the first one now Will later be last For the times they are a-changin'.