Most funds fail to beat the index. But a lot of funds say they have. There is a
simple explanation
GOLFERS are familiar with the concept of a mulligan the chance to retake a
shot. Give an averagely talented player enough mulligans and he or she will get
one close to the hole. And a version of the mulligan exists in fund management
too.
Readers will be familiar from past blog posts with the idea that actively
managed funds cannot be relied upon to beat the index. Many of these studies
are conducted in the US market, which is probably the most efficient (and thus
hardest to beat) in the world. But the same is true in Europe.
Figures from S&P Dow Jones Indices show that, over the ten years to December
2017, less than 15% of euro-denominated European equity funds beat their
benchmark; for emerging market funds, it was less than 3%; and global funds,
under 2%. For sterling-denominated funds, less than a quarter of both European
and UK equity funds beat the index.
But I took a closer look at the UK market, because of an intriguing detail. The
annualised return of UK equity funds was 7.27%; the index return (S&P s broad
market index) was 6.48%. So how come the average fund beat the market when, the
figures also show, most funds did not beat the market?
This is where the mulligan rule comes in. The ten-year performance returns are
for funds that have survived ten years. But most funds did not manage that;
only 43% of UK equity funds that were being operated at the start of 2008 were
still going at the end of 2017. The ones that closed were, inevitably, ones
that underperformed. If a fund survives for ten years, the chances are that it
had a pretty good record. That is why managers can advertise funds with strong
performance; if they have a bad fund, they can just close it and start again.
Ah, some investment advisers might say (indeed, one did tweet this to me) all
passive managers will underperform. But I looked at the Legal and General UK
index tracker, which is one of the largest, if not the cheapest. Its compound
ten-year return was 6.4% (it tracks the All-Share not S&P s index). It will
never be the best performer in the sector but clients can be sure it won t be
the worst either.
So beware of performance numbers. Another problem occurs with those funds that
do become stars (think Bill Miller at Legg Mason). They start small and then
their good performance generates investor inflows. Sometimes, it is harder to
outperform with a big fund than with a small one. But traditional performance
figures look at the return of the fund, not that of the average investor. Say
that the fund had $20m in the first year, and returned 20%, generating inflows
of $100m at the start of the second year. In the second year, the fund has
$124m under management and earns 5%. The fund will have a two year average
return of 11.8%. But most investors will have only earned 5% since they only
joined for the second year
Use a dollar-weighted return and the average investor can lag 2.5 percentage
points behind the average fund; that is what happened in the ten years to
end-2013, according to Morningstar. There is a reason why its is easier to get
rich investing other people s money than to get rich investing your own.