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Rekenthaler Report

Does Your Fund Manager Consistently Beat the Stock Market?

Probably not--but you shouldn't much care.

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Year After Year
Columnist Chuck Jaffe writes of the demise of the star mutual fund manager. About that he is correct. A quarter century ago, stock fund managers festooned the covers of national magazines, and I was a hit at cocktail parties. Those days are long gone. Now managers toil in near-obscurity, and … well, I don't actually get invited to parties, but if I did, I'd be chatting with the potted plants.

The eclipse in manager fortunes is understandable. As Jaffe writes, the top U.S. stock funds once routinely outperformed the S&P 500 each calendar year. Most famously, Legg Mason's Bill Miller generated a 15-year string from 1991-2005. For its part, Peter Lynch's  Fidelity Magellan (FMAGX) beat the S&P 500 nine years straight from 1975 through 1983, often by huge margins. While those were the two most spectacular examples, many other funds enjoyed substantial winning streaks.

Today's picture looks very different. Morningstar's Jeff Ptak looked at the 968 U.S. stock funds (oldest share class only) that have existed during the past decade and found that none had beaten the S&P 500 for more than six straight years. Worse for the cause of active managers, four of the 10 funds that managed the feat were Nasdaq 100 Index funds.

Still, that leaves six active funds with six-year winning streaks. Initially, that seems impressive. A portfolio manager who accomplishes such a feat will have no shortage of speaking invitations, and likely also no shortage of new investors. Then again, there is the question of what monkeys could achieve if given enough darts. What winning streaks would occur through pure chance?

If you think you know that answer, you don't. Determining the probability that a monkey will hit six straight black squares in 10 dart throws, on a board equally divided into black and white sections, is relatively trivial. Determining the probability of them doing so six consecutive times (but not more) out of 10 throws is not. Fortunately, Morningstar's Olgay Cangur came to my rescue--thanks, Olgay!

The chart below plots the actual showing of fund managers charted against the approximate expected showing (an exact closed-form solution not existing) of dart-throwing monkeys who had a 50% chance of landing in the black.

  Source: Morningstar.

Happily for portfolio managers, they were likelier than a monkey to succeed for at least two straight years. The bad news is most humans never got past two. The monkeys had many more long streaks, outnumbering the managers at every year from three to nine, including a whopping 13.6% to 4.4% advantage for four years.

My take:

1) Very broadly speaking, the average U.S. stock mutual fund isn't better than a costless, unmanaged index.

You already knew that.

2) That managers are likelier than the monkeys to put together two straight winning years owes to the nonrandom factor of market trends.

Each dart throw is truly independent; but one year's stock market may be influenced by the recent past. To give a simple example, small-company stocks rebounded from 2008's debacle to outleg the S&P 500 in 2009 and 2010. The risk trade was on throughout the period, thereby enabling most small-company stock funds to outperform in both calendar years.

This same effect probably has hurt the active managers' abilities to post longer strings. An investment trend may occasionally persist for half a decade or more, for example with technology stocks during the past six years, but generally the waters are choppier. Two years this way, perhaps 18 months that way, and so forth.

3) Thus, looking at calendar-year winning streaks does not seem to be instructive.

Even in Bill Miller's case, where the long 15-year period covered a wide variety of market conditions (not so for Peter Lynch's nine-year skein, which rode an extended small-company bull market), the consecutive string does not seem to signify much. The fund had been fairly average before beginning its streak and was distinctly below average after finishing it. Is Miller a great portfolio manager? He was during that era, yes. But it's hard to say anything more meaningful about his abilities.

And for shorter winning stretches, such as two years vs. four years vs. six years, the results can occur entirely by accident. After all, a full 40% of the "best" fund managers by this measure aren't properly fund managers at all, but rather a team that built an index. 

Here is a dramatic example of the failure of the winning-streak tally: The result for Warren Buffett.  Berkshire Hathaway's (BRK.B) longest calendar-year stretch, not just for a single decade but for the 20 years from 1995-2014, is shown below. (The height of Berkshire's line has no interpretation, so never mind about that bit.)

Source: Morningstar.

Hmmm. Not impressive. The longest successful stretch was only three years--and what the chart doesn't show, is that Buffett also had a three-year losing streak. Smells like a monkey to me. 

To put the matter another way, several dozen mutual fund managers, and even more coin-flipping monkeys, outdid the Oracle of Omaha on this score. Which means that the score fails, because Buffett is clearly better. Not only does he have 40 years' worth of previous performance to back up that claim, but Berkshire Hathaway would have turned a $1 million initial investment into just more than $11 million during that 20-year stretch from 1995 through 2014. During that same period, that amount in the S&P 500 would have grown to only $6.5 million.

Thus, what the consecutive-years measure missed with Buffett was more important than what it captured.

I suspect that is generally the case. There is information imparted by the overall decline in long fund winning streaks; as Jaffe writes (and academic studies concur), U.S. stock-fund managers enjoyed better success against the indexes back in the day. But the length of a given fund's thread indicates little. Screening funds based on their ability to string together outperforming calendar years is therefore not useful.

A Mental Illusion
Were you surprised by the size of the right-hand tail for the blue Random Expectations points? You might well have been. Most people tend to underestimate how frequently long streaks occur by chance. Morningstar's Patrick Caldon forwards this tale of a Hungarian lecturer who demonstrated this with an experiment:

The experiment goes like this: His class of secondary school children is divided into two sections. In one of the sections, each child is given a coin that they then throw two hundred times, recording the resulting head and tail sequence on a piece of paper. In the other section, the children do not receive coins but are told instead that they should try to write down a "random" head and tail sequence of a length of two hundred. Collecting these slips of paper, he then tries to divide them into their original groups. Most of the time he succeeds quite well.

The teacher's magic? In order to find the slips coming from the coin-tossing group, he simply selects the ones that contain runs longer than five.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler has a position in the following securities mentioned above: BRK.B. Find out about Morningstar’s editorial policies.