Mutual fund performance still matters

The age of the superstar mutual fund manager are over. That era seemed to come to a close with the end of the Internet bubble. Now hedge fund managers are the new rock stars and ETFs have taken mind share among sophisticated investors. So it begs the question: do mutual funds still matter?

Of course the do. Given the amount of positive press ETPs, or exchange-traded products, get you would think they had somehow surpassed open-end mutual funds in assets. However ETPs after still dwarfed by open-end mutual funds ($1.62 trillion vs. $14.80 trillion).* So there is still a great deal for us to learn from the industry.

John Rekenthaler at Morningstar has a great review of some recent research on mutual fund performance.** The research showed that team-managed mutual funds generated superior performance in part by taking on less risk. It is interesting to note that team-managed funds that include a female managers take on less idiosyncratic risk. The researchers also found a handful of other effects as well:

1)      Have a smaller asset base,
2)      Are younger,
3)      Come from a larger fund family,
4)      Have a lower expense ratio (duh),
5)      Have superior past performance,
6)      Are run by managers who have higher SAT scores.

It is interesting that there is nothing in there about active share, the degree to which the manager takes on active risk in pursuit of generating alpha. In that light it shouldn’t be surprising that smaller, younger funds are more likely to outperform. Rekenthaler notes that these findings are consistent with an industry that is trying to hold onto the assets it has as opposed to trying to grow assets. In short, mutual funds are no longer the growth engine they used to be.

These results definitely reflect a change in the nature of the fund industry. As this post by Brendan Conway at Barron’s that looks at another piece of research on fund performance we should be tentative in our approach to these type of studies because they are often time and data-dependent. All that being said in a world where indexed ETFs are essentially free what should investors look for in actively managed funds? In no particular order:

  1. Low expense ratio;
  2. High active share;
  3. Younger funds with smaller asset bases;
  4. Superior risk-adjusted historical performance.

We should note that historical performance need not be attached to the fund in question. There still are managers who are leaving big mutual fund shop to set up their own firms. Like other entrepreneurs these managers are incentivized to generate strong performance so as to grow their asset base etc. This is admittedly a small part of the fund world dominated by the huge fund complexes.

Under certain circumstances it can make sense to use actively managed funds for part of a portfolio. Again you should recognize the risks these managers take an ideally do so in the most tax efficient manner. The folks at Mutual Fund Observer do a great job of sussing out funds that have remained “in the shadows” or are just getting off the ground.

For investors in taxable accounts the advantages of ETFs is pretty clear. For the vast majority of investors their “default portfolio” should be both simple and indexed. Identifying and tracking active managers takes time, effort and risks underperformance. Fortunately for investors willing to go the active route there is some research that can guide you to make some more informed decisions along the way.

*Data per ICI.org as of January 31, 2014. About $2.7 trillion of that is in money market funds.

**See “To Group or Not to Group? Evidence from Mutual Funds” by Saurin Patel and Sergei Sarkissin at SSRN for the study referenced.

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