Fund Selection: Sense and Sensibility (2022)
Guido Baltussen, Stan Beckers, Jan Jaap Hazenberg, Willem Van Der Scheer, CFA
Financial Analysts Journal, 78(3), 30-48, URL
After finishing last week’s post, I coincidentally found a pretty good sequel. So this week’s AGNOSTIC Paper is again about mutual funds, but with a slightly different focus and much more practical details. Instead of US funds, the paper builds on a sample of globally investing funds that were available for European investors between 2008 and 2020. The authors also differentiate between equity- and fixed-income funds, institutional- and retail share classes, and more than 35 fund-categories. But despite all additional information, the overall message remains the same as last week: most active managers underperform after fees. However, the authors also show that it’s not entirely hopeless and suggest some simple rules to improve the odds of picking an outperforming fund ex-ante.
Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.
Setup and Idea
Well, the key question of the paper is the same as in many other studies on mutual funds: do actively managed funds add value when compared to a passive market-cap-weighted benchmark? Or more practically: can professional fund managers “beat the market” and achieve better performance than a simple ETF on an index like the MSCI World?1The appropriate benchmark depends of course on the asset class, region, and/or investment style. Since active funds charge substantially higher fees than their passive counterparts, they should perform better to compensate for that. Nobody wants to pay more for less, right?
In practice, however, this is unfortunately not the case. A large amount of empirical research unambiguously shows that the majority of active managers fail to outperform their benchmarks.2This general result is fairly robust and holds for different regions, time horizons, etc. Of course, this doesn’t mean that all active managers are bad. But statistically and in aggregate, investors were much better off with the passive benchmark. In fact, the literature also shows that the active managers who do outperform, usually fail to do it persistently and are very hard to identify upfront.3For example, Fama and French (2010).
Unsurprisingly, the authors find very similar results for their sample. Although I expected that, it is still cool4I know, this is a very nerdy definition of “cool”. I stand by it… because it is an out-of-sample validation of the numerous US-studies.
Data and Methodology
The sample consists of 6,605 mutual funds for the period between 2008 and 2020. The data is from Morningstar, a well-known service for global data on mutual funds. Notably, the authors explicitly highlight that the Morningstar database is free from survivorship-bias. This is very important because many funds are closed after dismal performance.5This is a very effective strategy for asset managers with enough resources. Just frequently close the underperforming funds and launch some new ones. With enough time and some luck, you end up with more outperformers that are easier to sell. But the cynic in me is speaking again, so I better stop here. In fact, the authors mention that 50% of the equity funds in their sample are “closed” as of 2020. So in 12 years about half of the mutual funds in Europe disappeared from the market. That’s quite brutal and investors should keep that in mind when looking at the other half that is still living.
Note that the mutual funds are European but in the sense that they are available to European investors. The funds also invest in non-European assets and pursue very different strategies. So strictly speaking, it’s a sample of globally investing funds that are available to European investors. The results are therefore not limited to the performance of active managers in European markets. Instead, they show how much value active managers created for European investors.
On a more granular level, the sample splits into 5,533 equity- and 1,072 fixed income funds. The equity funds cover 35 different categories, the fixed income funds only 7. The covered assets grew from €656B in 2008 to €1,473B by the end of 2020. To obtain investable benchmarks, each of the 42 categories includes at least one passive fund. In addition to that, the authors also source the official fund benchmark from Morningstar.6Official benchmarks are usually indices which are not directly investable. The comparison to a passive index fund is therefore more realistic from investors’ perspective. They also differentiate between retail- and institutional share classes. The latter offer lower fees but usually require commitments to larger investments.
The methodology behind the key results is again quite simple and doesn’t involve sophisticated models.7I absolutely don’t mean this in a negative way. It’s really great and more a sign of skill to derive interesting results with simple methodology. In fact, the main takeaways are essentially statistics on mutual funds presented in an intuitive way. The authors also report their results for each of the 42 fund-categories and thus provide a lot of details. So this is definitely a great paper if you need some detailed facts about the European mutual fund space. Who doesn’t want to know the average retail-fee for European Natural Resources funds?8Again a sign of nerdiness… Anyway, the answer is 2.01% per year.
Important Results and Takeaways
In aggregate, active managers underperformed the passive alternative
The authors start with the asset-weighted outperformance of funds in total, within each of the 42 categories, and across retail- and institutional share classes. Similar to last week for the US sample, the results are anything but a sales-pitch for active fund managers.
Equity funds outperformed the passive alternative by 0.42% before fees but charged so much that this number turns into -0.60% after fees. For fixed income funds the numbers are with -0,1% before- and -0.68% after fees even worse. To be fair, none of the four numbers are significantly different from zero at common significance levels. That said, I don’t think “We non-significantly outperform and charge an immense fee for that.” is very convincing. But to be fair once again: these results of course don’t mean that all active managers are bad. For example, equity fund managers generated outperformance within 17 of the 35 categories even after considering fees.9Some of the best performing funds are not even available for retail investors. But this is more of an issue in the hedge fund world.
But since fees remain the key issue for net performance, the authors dig a little deeper and examine retail- and institutional share classes. The average fee for institutional share classes was 0.82% while retail investors paid with 1.71% more than twice as much. This is unfair but it’s the way the industry works: fund management requires scale and investors who supply more money are more attractive for asset managers and therefore enjoy lower fees.
This fee-difference of course also affects after-fee returns. On average, retail equity funds underperformed the passive benchmark by 0.8%, institutional share classes “only” by 0.11%. For fixed income funds, the underperformance is with 1% for retail- and 0.16% for institutional share classes again even worse. The following chart again summarizes those results and shows cumulative outperformance over time.
For equity funds, the overall message remains unchanged. In aggregate, active fund managers did a decent job. Both the retail- and institutional share classes generated cumulative outperformance of about 3-5% over the sample period. That’s not outstandingly good but also not bad. Outperforming the index by even modest amounts is very difficult and definitely requires some skill (or luck). The problem, however, remain the fees. Asset managers charged way too much for their services such that investors underperformed simple passive benchmarks after fees. Unsurprisingly, this is especially relevant for the more expensive retail share classes.
For fixed-income funds, the pattern is very similar and even more pronounced. In this asset class, the average fund underperformed even gross of fees. Although uncool for investors, the result is again quite cool for researchers because a different asset class is also an out-of-sample test of the numerous studies on equity mutual funds.
Overall, the main results paint a very similar picture like last week. In aggregate, active managers performed worse than their passive benchmark and investors were worse off. For some of them that’s because of lacking skill but the main problem are fees. Active managers simply charged more in fees than they added in value. For example, 0.42% gross outperformance versus 1.71% in fees for retail equity funds – not a great deal for investors.10The authors also show that active managers overcharged in terms of absolute value added. According to the literature, absolute metrics are preferable to measure this because they appropriately consider investors’ wealth. However, I haven’t included this analysis because the results show the same overall pattern. Furthermore, I consider outperformance verus passive benchmarks more intuitive to understand the issue. However, the authors also show that investors can (try to) use this to their advantage…
As I mentioned earlier, the paper includes much more detailed statistics and also presents all results for each of the 42 categories. So this was just the tip of the iceberg and I refer those who want more details to the paper.
Cheap funds with good track records were more likely to outperform
A simple thought experiment: two active managers offer their funds. Both of them are equally smart (or dumb) and have the same chance to outperform their passive benchmark. However, the first one charges 1% of assets per year, the second only 0.5%. You don’t need to be a genius to figure out that, all else equal, investors should always choose the cheaper fund.
Based on this idea and the previous results, the authors suggest three simple fund selection rules (and some combinations of them) to improve the odds of picking an outperforming fund.
- Rule 1: Focus on the 25% of funds with the lowest fees.
- Rule 2: Focus on the 25% of funds with the strongest risk-adjusted performance over the last 12 months.
- Rule 3: Focus on the 25% of funds that deviated the most from their benchmarks (highest tracking errors).
The reasoning behind those rules is straight forward. All else equal, cheaper is always better for investors. Strong historical performance may suggest some degree of manager skill. And finally, deviating from the benchmark is by definition required to outperform.11You can’t be better than the benchmark by being the benchmark.
As simple as the rules may seem, funds that scored well on those dimensions had a higher chance to outperform (at least in the authors’ sample). They also generated positive outperformance versus the passive alternative as compared to a random selection. The improvements are also fairly consistent across the different fund-categories. For example, a combination of Rule 1 and 2 improved the outperformance of equity funds in 31 of 35 categories. So by and large, there seems to be evidence that investors who want to invest in active funds should at least focus on the cheap ones with good track records. I think that’s actually quite intuitive but still nice to see it in the data.
Conclusions and Further Ideas
Two independent studies, different regions and strategies (although with some overlaps), different sample periods and yet the same result: on average and after-fees, investing in mutual funds was a bad deal for investors. Last week’s paper shows this for a sample of domestic mutual funds in the US and this week’s paper finds very similar results for a sample of globally investing funds that are available to European investors.
I repeat myself, but the main problem is that active managers simply charge too much for what they are delivering.12Yes, I deliberately switched to the present tense because I do believe that this pattern still exists today. Unsurprisingly, this is especially severe for retail investors who don’t have access to the cheaper institutional share classes. The authors also show that this pattern is by no means limited to equity markets. In fact, some of the results are even worse for fixed income funds. Without knowing any study or data, I would guess that the pattern is very similar for other asset classes as well. Financial markets are just very competitive and it’s hard to outperform.
So what should we do with the results? Well, the same mantra as last week is still valid. Except for those who have a legitimate reason to believe they can identify the few outperforming managers upfront (which is difficult), I would argue that most people should just go for a cheap passive index fund or ETF. But if investors (for whatever reason) still want to invest in actively managed funds, they should at least follow the proposed selection rules and focus on cheap funds with a good track record. How skilled is the fund manager and how much charges she for her services? Those are the points that ultimately matter.
- AgPa #72: Machine-Reading of Private Equity Prospectuses
- AgPa #71: Go Where the Earnings (per Share) Are
- AgPa #70: Equal vs. Market Cap Weights
- AgPa #69: Rebalancing Luck
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|1||The appropriate benchmark depends of course on the asset class, region, and/or investment style.|
|2||This general result is fairly robust and holds for different regions, time horizons, etc.|
|3||For example, Fama and French (2010).|
|4||I know, this is a very nerdy definition of “cool”. I stand by it…|
|5||This is a very effective strategy for asset managers with enough resources. Just frequently close the underperforming funds and launch some new ones. With enough time and some luck, you end up with more outperformers that are easier to sell. But the cynic in me is speaking again, so I better stop here.|
|6||Official benchmarks are usually indices which are not directly investable. The comparison to a passive index fund is therefore more realistic from investors’ perspective.|
|7||I absolutely don’t mean this in a negative way. It’s really great and more a sign of skill to derive interesting results with simple methodology.|
|8||Again a sign of nerdiness… Anyway, the answer is 2.01% per year.|
|9||Some of the best performing funds are not even available for retail investors. But this is more of an issue in the hedge fund world.|
|10||The authors also show that active managers overcharged in terms of absolute value added. According to the literature, absolute metrics are preferable to measure this because they appropriately consider investors’ wealth. However, I haven’t included this analysis because the results show the same overall pattern. Furthermore, I consider outperformance verus passive benchmarks more intuitive to understand the issue.|
|11||You can’t be better than the benchmark by being the benchmark.|
|12||Yes, I deliberately switched to the present tense because I do believe that this pattern still exists today.|