Wednesday, September 25, 2013

A Reader Question about Choosing Winning Mutual Funds

A long-time reader who prefers to remain anonymous asked an interesting question about a strategy to pick winning actively-managed mutual funds. Here is an edited version of his question:
I'd love to hear your input on a friendly discussion with a good friend on active mutual funds versus passive indexing. I fall on the indexing side of the debate but I'm having trouble finding flaws with the approach he's been using.

He looks for 5-star active funds with "low-risk, high-return" characteristics as dictated by Morningstar and/or Scotia Research, then selects funds that have performed better than the group average over short and medium term (1 month to 3 years) under the same management. He will then hold these funds and review every 3-6 months or so, selling them if they no longer exceed the group average returns.

Whenever I pick a suitable index (regardless of asset class, though he favors Canadian and Global Small Cap), his funds have almost always done considerably better than the index, even after accounting for the high MER (often 3%+).

Other than the risk of that particular manager departing the fund right after he buys it, I'm having trouble identifying the downside.

Is it a viable approach or just luck so far?
There was a short period of time when I used to pore over mutual fund listings trying to puzzle out which funds would outperform in the future. However, the studies I’ve read all agree that this is futile because good performance does not persist into the future.

It isn’t possible for such studies to try every possible way to choose funds. You could focus on any one of several different time-periods for returns (1 month, 3 months, 6 months, 1 year, 3 years, 5 years, or 10 years). You can vary how often you make changes, and you can add in other criteria such as the reader’s friend did with manager persistence. So, there is no study that specifically looks at the exact strategy described above.

When someone looks at past data and tries out different strategies, this is called data mining. Even if 90% of funds fail to match their benchmark index over 10 years, you can always use data mining to find a strategy that would have chosen mostly funds in the winning 10%. Even if the strategies are just random, eventually one of them will happen to choose past funds that outperformed.

Perhaps the reader’s friend didn’t do any data mining and just happens to have a strategy that has performed well recently. The problem we’re now faced with is that we can’t distinguish skill from luck. Maybe this new strategy will perform consistently well for the next 20 years. But more likely, it will perform randomly, and because most funds underperform, a random strategy is likely to underperform. If this turns out to be the case, then the 3% MERs will become quite painful.

In the end it’s impossible to tell if an active strategy is a winner or if the investor is simply lucky. But just going by the track record of supposedly winning strategies, I’m not optimistic about this one. A further problem is that even winning strategies don’t work forever. I can’t say for certain that the reader’s friend is simply lucky, but I won’t be betting any of my money on this strategy.


14 comments:

  1. The market has a remarkable way of dealing with "great new trading methodologies" by either disproving them, or simply making them moot over time (i.e. everybody else does the same, or finds a way to combat it).

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    1. @Alan: Good point. If this strategy works, it isn't likely to work for long.

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  2. This sounds like precisely the wrong approach since it is picking funds that have recently been hot. Maybe the frequent reviews help to minimize losses if they revert immediately instead of continuing to trend (how much is his time worth?). If you were to evaluate the returns of this strategy, it would be worth doing it at the portfolio level.

    The only approach that does sound appealing to me is to pick funds based on 3 factors:
    1) Good performance over the last 10-20 years to show they have long-term value
    2) Good reasons to believe they can find an advantage, such as a value investing method
    3) Underperformance over the last 2-4 years, since this is an inevitable sign that the manager sticks to their strategy regardless of short-term fears

    I've heard of 2-3 managers that appears to meet these criteria but I don't think it's worth my time to investigate further.

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    1. @Richard: In general, chasing hot funds is a bad idea, as you say. But if you try enough variations it's always possible to find a strategy that works for a while. I'm not optimistic about your strategy either, but I can't say for certain that it won't work.

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  3. Hi, thanks for the post (I'm the one who mentioned the question in the first place...)
    I can tell you my friend (yes, it's a real person, not me pretending to be someone else... :-) ) does use 'data mining' in the sense that he reviews recent performance numbers. I shudder at how concentrated his portfolio is, but it seems to be working for him. As for how long it takes, a few minutes, maybe an hour at most, every few months. All funds are no-load (they get their share on the high MER...) so not too many transaction costs.
    I'll be looking into this further, but as Richard said, perhaps the frequent reviews might be a good way to keep things under some control..

    Thanks!

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  4. My question for anon is whether his strategy outperforms? Does he calculate his rate of return properly because he is selling his funds that don't outperform?

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  5. I'd think it was a slightly worse stategy than stock picking, because you pay the MERs as well as lose on the NAV if the underlying stocks tank. If I was going to work that hard to pick an investment, I'd pick a stock. If I was picking a mutual fund, I'd probably stick to an "entire market" one. Obviously, though, this strategy is working for one person for now. Whatever makes him/her happy.....

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    1. @BetCrooks: Calling this strategy worse than stock picking is quite damning because most individual investors who pick their own stocks get terrible results.

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  6. This strategy is likely to continue to out-perform, and there is research to support it. I have used something similiar to this approach for more than a decade with success. ETFs would be better than mutual funds with high MERs.

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    1. @Dale: I thought you were a sell in May and buy back in the fall guy. Can you point to this research?

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  7. I hope not to start a battle with the index-zealots. See ch 5.5 (in Part 3) of my website at www.straighttalkinvesting.ca. And no, I don't sell in May.

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    1. @Dale: That's the Dale I remember: hurling insults and directing me to a web page filled with pitches for your newsletter.

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  8. @mj Be nice. It's Friday. The references and citations are on my site. My site is biased. It says so. How have I insulted you lately?

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