Taking a Closer Look at Fund Performance
In a world where we are bombarded with media hype about different stock picks, get rich quick schemes and claims that some managers have a crystal ball for how to beat the market, a wise investor is one who blocks out the white noise and pays attention to facts and science. A recent article written by Philipp Meyer-Brauns, PhD, an associate at Dimensional Fund Advisors, looks at reporting on mutual fund performance and reveals that there is often not enough perspective given to all of the factors that one must take into account when determining true performance.
According to the article, new “research has deepened our understanding of the sources of expected returns. In light of the evidence showing robust profitability and investment premiums, Fama and French (2015)i introduced a five-factor asset pricing model that incorporates factors for the market as well as for size, value, profitability and investment.” ii
When more perspective is given to total performance by looking through a more complex lens, the true performance and returns of many actively managed funds do not look as nice as they do through the rose colored glasses of the reports we see taken from the traditional capital asset pricing model that uses only the market as a whole as it’s variable.
The reason for the disparity in results can, for the most part, be blamed on the fact that most reporting doesn’t account for the fees and costs associated with active management.
“Using simulations to account for the effect on random chance on performance, the results suggest that most traditional active managers delivered subpar performance, net of fees, after accounting for their exposures to the market, size, value, profitability, and investment factors...The evidence suggest it is unlikely that more than a few active funds had positive true alphas relative to the Fama/French five-factor model.” iii
If the last quote was like reading Greek, here is the bottom line. If you are picking stocks or trying to time the market, it is highly unlikely that any value will be added to your portfolio. And it is entirely likely that this type of behavior is detrimental to your portfolio over the long term.
While there is plenty of success in the market among fund managers, it is important not to confuse skill with luck. In the Fama/French study the research took into account that “some funds will perform very well—and others very poorly—just by random chance.” Using chance as part of the research, enabled them to separate actual alpha (active returns on investments) and alpha by chance. What they found by using this method is that “there is strong evidence that the vast majority of active managers are unable to produce excess returns to cover their costs.
Basically, unless a fund gets lucky, investors should really never slate their expectations on the outperformance of even the best performing funds.
So why is it important?
Explaining what not to do as an investor is as important as explaining what to do. It is not good enough to tell our clients and potential clients that we do not subscribe to active management. We feel it’s important to explain why.
Research and science shows that it is nearly impossible to outguess the market. Research shows that active management attempts to do precisely that. Research shows that it is not a winning battle. Finally, research shows that passive management, though without the possibility of the chance upside, has substantially lower fees and costs and will likely maintain steady growth over the long term and remain in line with current and future market conditions.
i In asset pricing and portfolio management the Fama-French three and five-factor model is a model designed by Eugene Fama and Kenneth French to describe stock returns. Fama and French were professors at the University of Chicago Booth school of Business.
ii Philipp Meyer-Brauns, PhD, “Mutual Fund Performance through a Five-Factor Lens,” Research Matters, Dimensional Fund Advisors, August 2016
iii Ibid