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Mutual Funds in Lake Wobegon

Are all funds above average?

John Rekenthaler, 06/27/2015

Too Good to Be True
The claims made for exchange-traded funds have probably raised your suspicions. Value is good. Momentum is good. Profitability is good. Dividends are good. Fundamental weightings are good. Equal weightings are good. Low volatility is good. Low liquidity is good. If you summed all the claims of ETFs, it seems that just about every investment strategy is good. Pick a factor; it will lead to superior results.

But that can't be right, can it?

Well of course, it can't. Run 1,000 searches in mutual fund data for patterns that are statistically significant at the 5% level, and you'll get roughly 50 "successes." And ETF providers conduct far more than 1,000 searches. Thus, many if not most of their positive findings are accidental. Or they are genuine, in the sense that the factor is indeed associated with extra return--but at the cost of extra risk.

Wharton's Denys Glushkov takes that one step further, effectively denying the usefulness of the entire endeavor. In a recent paper that evaluates the performance of strategic-beta ETFs, Glushkov writes, "I find no evidence that SB ETFs significantly outperform their risk-adjusted passive benchmarks. Positive returns from intended factor bets are offset by negative returns from unintended factor bets resulting in an overall performance wash."

(That's far from the final word on the subject, as the funds' histories are short. Also, while Glushkov's approach is the right way to measure the overall promises of the strategic-beta industry, it cannot measure the funds' usefulness. After all, if the winning funds continue to win, and the losers continue to lose, then smart-beta funds will be great choices for the savvy investor.)

Now, it seems, the same process is occurring for active mutual funds. There are now several attributes of the successful active mutual fund, according to research published by various parties. 

1) Bigger (and cheaper) is better.
This spring, Fidelity released a study showing that, in aggregate, relatively cheap large-company U.S. stock funds from giant fund companies (technically, the five largest managers each year of active U.S. stock mutual funds) had beaten their prospectus benchmarks over the previous 23 years. The effect was quite modest, but it was positive.

(This study, as with other studies cited in this column, ignores the effects of any front-end loads, but includes all ongoing fund expenses.)

is vice president of research for Morningstar.

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