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A Common Investment Strategy Guaranteed to Fail

Sixty-two percent of US Large Cap Funds lagged behind the Standard & Poor’s 500 benchmark over the previous five-year period, according to the year-end 2010 Standard & Poor’s Indices vs. Active Funds Scorecard. Disappointing as this may sound, this result is better than most similar studies, most historical results, and the S&P results for other market segments.

A 62 percent chance of underperforming means a 38 percent chance of outperforming. This is not encouraging, but the optimistic among us may want to test these odds. But that is for one fund. What happens if you want to build a portfolio of more than one fund? The odds start to stack up against you very quickly. Let’s also assume that funds that outperform do so by an equal magnitude on average as the amount of underperformance by those lag. Once again, history shows this is a very generous assumption.

If you own six funds, your chance of out-performance drops to about 15 percent. With twenty funds, the odds drop down to about 9 percent. This is still too high to guarantee failure, but there is no rational reason anyone would want their money facing a headwind like this.

One of the biggest fallacies in investing is having confidence in a manager because of a strong track record. Of the thousands of active managers, statistically speaking, some of them simply have to outperform looking backwards. This has nearly nothing to do with what will happen in the future – in fact, the opposite may be the case.

According to another Standard & Poor’s study released in March, 2010:

  • Very few funds manage to consistently repeat top-half or top-quartile performance. Over the five years ending March 2010, only 1.7 percent of large-cap funds, 2.2 percent of mid-cap funds, and 4.6 percent of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Random expectations would suggest a rate of 6.25 percent.
  • Looking at longer term performance, 18.5 percent of large-cap funds with a top quartile ranking over the five years ending March 2005 maintained a top-quartile ranking over the next five years. Only 12.7 percent of mid-cap funds and 25 percent of small-cap funds maintained a top-quartile performance over the same period. Random expectations would suggest a repeat rate of 25 percent.

The simple solution to avoid this problem is to build a diversified portfolio with low cost index ETFs. We believe we have found an even better solution. Our investment approach is called Smart Indexing, and we think it provides significant long-term advantages over standard capitalization weighted passive indexing.

You usually don’t hear much about these headwinds of mutual fund investing because financial companies are making a lot of money selling actively managed mutual funds, but the numbers become very compelling very quickly. If you have a portfolio build from a bunch of mutual funds, we encourage you to reevaluate your strategy.

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