Pick Good Funds

The Wall Street Journal and the financial community have been abuzz about passive investing.  I wrote about settling for average and outrunning a bear via active management previously.  The newest argument for choosing active management over passive is that investors should choose ‘good’ managers, not average or bad managers. Why didn’t anyone think of that before?  Choosing a good manager sounds like common sense, but really this is an attempted rebuttal of the fact that benchmarks outperform 70-80% of actively managed funds.  Capital Group (parent company of American Funds) even published a scorecard in a sort of homage to S&P’s SPIVA report that touts the performance of ‘good’ funds.  Tim Armour, chairman of Capital Group, asks why an investor would buy Blockbuster stock in the early 2000s when they could have bought Netflix – the assumption being that a good manager would have bought Netflix while an index would have been forced to ride Blockbuster into the grave.  Sure, the benchmark beats bad and average managers, but the good ones rise to the top and stay there, right?

If you have been following this website at all, you already know how this ends.

So what happens when we screen for ‘good’ managers?  American Funds suggests that active funds with low expenses and have managers that invest their own money in their own firm’s funds are ‘good’.  In the US Large Cap Equity space, seven American Funds passed this hurdle.  Why does one fund company have seven different funds investing in the same asset class?  That’s a question for a different day.  For now, let’s accept that these seven funds are ‘good’ and take a look at how they stack up against the S&P 500 (this is the bogey shown on the American Funds Active Scorecard).  By the way, these funds are good.  They consistently rank at the top of their peer groups and the American Funds investment process is excellent.  My conflict is with the idea that picking a manager that consistently beats the market is easy and also with the data Capital Group is using to back up their argument.

The Active Scorecard shows that over the last 20 years (ending 6/30/2016) the seven funds each beat the S&P 500 more than half the time over 10 year rolling periods.  Four of the funds beat the index over 90% of the time!  One fund won almost 80% of the time while the other two funds did a bit better than a coin flip.  Over 5 year rolling periods (shorter time frame, more data points) for the last 20 years, the results come down to earth a bit with 5 out of 7 funds beating the index 70% of the time or more.  One fund beat the index 64% of the time and the other beat the index 48% of the time.  This is still good!  Over 3 year rolling periods, the results become mixed.  Two funds beat the index more than 70% of the time, two beating more than 60% of the time, one beating 58% of the time, and the other two funds beating the index 50% of the time or less.  None of the ‘good’ American funds beat the index more than 60% of the time over 1 year rolling periods.  Three of the funds won less than 50% of the time.

At first glance, it looks like these good funds achieved good results relative to the S&P 500 on a consistent basis.  Something interesting happens when we change the timeframe, though.  I ran the numbers through Morningstar Direct (as of 9/30/2016, so they’re a little different from the Active Scorecard) and performance drops off, in some cases tremendously.

Percentage of rolling periods funds beat the S&P 500. Data from Morningstar Direct

If we look at the last 7 years instead of 20, the ‘good’ American funds get trounced by the S&P 500. The last 7 years covers the recovery from the bottom of the financial crisis.  Active management is supposed to help during downturns so maybe 7 years is not a long enough timespan.  Over the last 10 years, the results aren’t much better, but they are better.  Seeing a pattern, I looked at rolling periods since each fund’s inception.  If the pattern holds, the American Funds should dominate the S&P 500 over periods longer than 20 years, right?  Since inception results only improved for two out of the seven funds.  The other funds saw dramatic drop-offs from their 20-year showings.

It looks like the American Funds had a great run from 1996 through 2006, but have struggled to keep up with the S&P 500 since then.  My initial conclusion was that it has become more difficult to beat the index due to an increasingly efficient market and alpha decay, but the funds’ struggles before 1996 don’t confirm that.

These results don’t surprise me.  For active large cap managers as a whole, the S&P Persistence Scorecard shows that 8.5% of the top quartile were able to maintain their top-quartile ranking over three years (as of August 2016).  Less than one percent were able to maintain a top quartile ranking over five years.  What this means is that while 20-30% of active managers outperform their benchmark in any given year, it tends to be different managers each year.  This is what makes picking ‘good’ managers so difficult.  There’s a new crop of outperformers every year.  To make things even harder, according to new research from First Eagle Investment Management investors stick with an equity mutual fund for 3.8 years.  Investors need a solid financial plan or else they may find themselves sold a product due to its 10 year returns, but then acting on short term turbulence.

Oh, and for the record, Netflix dropped 76% from January 2004 through March 2005 in response to Blockbuster entering the mail-delivery movie space.  It recovered from that drop by April 2008 then nosedived 80% from July 2011 to September 2012 before recovering a year later.  Tim Armour says “you don’t need 20/20 hindsight to have made the right call”.  Tell that to Netflix founder Reed Hastings who tried to sell his company to Blockbuster for $50 million in 2000.    Apple stock was trading below $10/share in 2003.  Buying that looks obvious in hindsight, too.