Wednesday, December 15, 2010

How to Replicate the Performance of Dynamic Funds

Dynamic Funds have 7 mutual funds that have beaten their respective stock index benchmarks over the past 10 years despite sky-high MERs. Jonathan Chevreau suggests that this is reason for index fund proponents to eat crow (the web page containing this article has disappeared since the time of writing). Both Canadian Capitalist and Canadian Couch Potato did an excellent job of explaining the problem of identifying outperforming mutual funds before they outperform. I won’t repeat their arguments. But I will show how to replicate the performance of Dynamic Funds with a dead-simple strategy.

Let’s say that we run a mutual fund company that wishes to charge a 4% MER. (Why water-ski behind a small yacht when it could be a big yacht?) But we also want 7 of our funds to outperform the S&P TSX index over the next 10 years. This sounds like a tall order, but it’s actually quite easy.

To begin with we’ll create 112 (7x16) mutual funds in our family. The reason for this number will become apparent later. We’ll invest each one in the S&P TSX index and collect our 4% MER each year. The only thing left to add is some bets.

Initially, we’ll pair off the funds into 56 pairs. Suppose that funds A and B are paired. Fund A will enter into a derivative contract and fund B will take the opposite side of the same derivative contract. We’ll stop the betting when one fund is up 25% and the other is down 25%. The type of derivative doesn’t really matter and it doesn’t matter whether fund A or B comes out ahead.

Once the betting is complete, all the funds will have returns with three components: the stock market return, the 4% per year MER loss, and +/- 25% from the derivative betting (56 winning funds with +25% and 56 losers with -25%).

Next we match the 56 winning funds in pairs and repeat the betting process for another round. The losers from the first round won’t do any further betting. When this round ends we’ll have 28 funds that have won twice and have had two 25% bumps in return.

You guessed it. We will then have another round of betting using the double winners to give 14 triple-winners. A fourth rounds gives 7 quadruple-winners. All 112 funds will get the index return less the 4% MER each year and then plus or minus the results of the betting. Note that all this betting could be spread fairly smoothly across 10 years so that the 25% bumps wouldn’t necessarily be very visible. Here are the resulting per-year returns for the funds over a decade relative to the S&P TSX index:

7 funds: +5.0%
7 funds: -0.2%
14 funds: -2.4%
28 funds: -4.5%
56 funds: -6.6%

Even after paying the huge 4% MER, 7 of the funds outperformed the index by 5% per year for a decade! We collected this high MER for a decade and all we had to do was invest all the money in an index and trade some derivatives. We never had to worry about which stocks or derivatives might perform best. As a bonus we are left with 7 funds that we can tout as long-term stars.

The reader may object that while we’re left with 7 star funds, there were also 105 underperformers. According to Canadian Couch Potato, Dynamic has about 100 funds with only 7 showing outperformance. So, my scenario mirrors Dynamic’s case quite well.

I have no idea how Dynamic Funds achieved their results, but we see that my strategy can achieve similar results with no skill at all.

11 comments:

  1. Well done... some great thought in this post. Thanks.

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  2. @Patrick and @Doctor Stock: Thanks. I had fun with this one.

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  3. Thanks for the mention, M. Obviously fund families don't use such a coldly mechanical strategy, but it's undoubtedly true that they create a large variety of funds, quietly fold the losers and market the hell out of the winners, almost inevitably arriving at the same place as the fund family in your example.

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  4. Thanks for the mention Michael. Let's check in a few years how many of these market-beating funds continue to their out performance. If the past is any indication, it is likely to be random.

    It's hard to beat the benchmarks when saddled with 2.5% fees and a cash position.

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  5. @Canadian Couch Potato: I think one thing my example shows is how likely a fund family is to have a few outperformers over a decade even by just luck.

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  6. @CC: I was thinking some more about all this and I think I can create a mechanical system of continuously producing a handful of lucky winners and quietly closing down losers so that at any one time there are one or more funds with winning streaks of 20 years or more.

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  7. Well written post, thanks Michael.

    Though think caution is warranted for anyone looking to lump all active managers records into the 'luck' or 'gambling' camp.

    Here's a balanced article from David O'Leary @Morningstar that I enjoy- http://www.morningstar.ca/globalhome/Industry/News.asp?Articleid=285838

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  8. For some reason the following comment from Chris Stephenson seems to have disappeared:

    Well written post, thanks Michael.

    Though caution is warranted for anyone looking to lump all active managers records into the 'luck' or 'gambling' camp.

    Here's a balanced article from David O'Leary @Morningstar that I enjoy- http://www.morningstar.ca/globalhome/Industry/News.asp?Articleid=285838

    @Chris: Thanks. I agree that we shouldn't say that all successful active managers are just lucky. However, my strategy illustrates the difficulty of distinguishing skill from luck.

    The article you mention contained some interesting points, but I always react negatively to anyone who suggests that I open my mind. If I think about something for decades and finally make a choice, this is not evidence that my mind is closed.

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  9. I love this!

    You know, Michael - if you would use your genius for evil, instead of good - you could be a pretty rich guy! :)

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  10. @Mike: Actually, this post is part of my resume. I'm hoping for a job offer from Evil Inc. :-)

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