Mutual fund charts of the day

By Felix Salmon
November 30, 2009
Fama and French have a very long blog entry (over 5,000 words) about the latest version of their paper on mutual fund returns. As you might expect from research sponsored by an index-fund company, it shows that active mutual-fund managers fail to outperform the market. But at least it does so with pretty charts.

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Fama and French have a very long blog entry (over 5,000 words) about the latest version of their paper on mutual fund returns. As you might expect from research sponsored by an index-fund company, it shows that active mutual-fund managers fail to outperform the market. But at least it does so with pretty charts.

Here’s what happens when you compare actual before-fees returns from mutual-fund managers (the blue line) with what you’d expect if no managers had any skill at all, and the returns were simply distributed by chance (the red line).

luck_f2_updated.gif

On the left hand side of the chart, you see actual fund managers significantly underperforming what you’d expect by luck alone. On the right hand side, however, it seems that if you’re skilled at manager selection, there is a glimmer of hope that you might find a little bit of alpha. Not a lot, but something statistically significant.

Unfortunately, all that alpha — and then some — gets eaten away by fees. Here’s the chart for after-fees returns:

luck_f1_updated.gif

The red line, remember, is the distribution of returns you’d expect if all mutual-fund managers had an alpha of zero. The blue line is actual returns. Fama and French conclude:

For the vast majority of actively managed funds, true α is probably negative; that is, the fund managers do not have enough skill to produce risk adjusted expected returns that cover their costs.

Which comes as no surprise, but it’s still good to see some relatively solid empirics here. Anybody wanting to make an intellectually-credible case in favor of investing in actively-managed mutual funds is going to have to attack this paper head-on.

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