Mutual Funds in Lake Wobegon

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.)

2) More manager ownership (and cheaper) is better. Two years before, American Funds published a report showing outperformance from relatively cheap stock funds from companies with portfolio managers who tended to hold their own funds. Overall, such funds comfortably beat the S&P 500 over all intermediate to long time periods.

3) Boutiques are better. AMG has a new study covering the past 20 years, demonstrating that stock-fund accounts from "boutique" investment firms outdid stock-fund accounts offered by other organizations, in nine of 11 fund categories. The categories also fared well against the benchmark indexes, matching the indexes at worst and beating them by an annual 2 to 4 percentage points at best.

AMG's figures are of institutional accounts, not registered mutual funds, but the argument should carry. After all, most investment managers these days sell to both retail and institutional buyers.

(AMG defines boutique firms as those companies with actively managed funds that only are only in the business of investment management (as opposed to offering additional financial services), that have less than $100 billion in assets, and where the principal owners control at least 10% of the organization.)

4) Active Share (with an asterisk) is better. Originally, the inventors of the Active Share measure (which calculates how much a fund's holdings differ from that of a benchmark) claimed that U.S. stock funds with high Active Share scores had better performance. Critics poked at that conclusion, arguing that much if not all of Active Share's apparent success owed to a disguised small-company effect.

In response, Martijn Cremers joined with a new author, Ankur Pareek, in refining the case for Active Share. Now, writes the duo, "Among high Active Share portfolios-- whose holdings differ substantially from their benchmark's holdings--only those with patient investment strategies (with long stock-holding durations of at least two years) outperform their benchmarks on average. Funds trading frequently generally underperform."

5) Low cost is better. This, of course, is demonstrated in many studies and is undisputed.

If you're not skeptical yet, consider that each of the first four parties have reason to find what they do. Fidelity is huge, American Funds has a lot of manager ownership, AMG owns boutiques, and academic authors benefit when their findings are meaningful.

To my surprise, though, I find the active-fund story cohesive. More so than with strategic betas and ETFs.

While it's true that the active-fund findings seem to cover a lot of ground, thereby implying that most funds are above average because they meet at least one of the five conditions, that is something of a mirage. Only five fund companies qualify via Fidelity's bigger-is-better screen; a mere 5% of stock funds make American Funds' ownership-and-cost cut; few funds have the combination of high Active Share scores and low turnover; and fewer active funds yet are outright cheap.

Finally, although many fund companies may qualify as boutiques, not many funds do, because such companies have limited lineups.

Also, the research behind the points may be new, but the ideas behind them are established--and from the most credible of sources, Jack Bogle. Per Bogle's dicta:

1) Low cost wins.

2) Low turnover wins.

3) Fund-manager ownership is good.

4) Fund-company partnerships are good.

I therefore reject the headline's premise. The various active-management studies would seem to be self-contradictory, but they are not. They share the common theme of stewardship. Protecting shareholder monies by cutting expenses and turnover is being a good steward. So is having portfolio managers invest in their own funds, having the fund-company owners hold large stakes in their businesses, and restricting the company to doing only the business of investment management.

In short, most mutual funds are not above average. But, more often than not, the funds run by good stewards are.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com 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.