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).


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:


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.

10 comments so far

Felix,I don’t agree with your characterization of their paper as “research sponsored by an index-fund company”. That description makes it seem like the research was influenced by some for-profit company, rather than the product of two top-tier research institutions. There’s no evidence that I can see that DFA (the company I’m assuming you’re thinking of) supported or solicited this work in any way.

Posted by Andy | Report as abusive

Seems to me that this paper/blog post both argue in favor of the EMH. Having studied under some very Efficient Markets Hypothesis-favoring professors, I’ve learned to find the unspoken qualifications to the arguments presented. One of the most unspoken points of any EMH discussion is what, exactly, constitutes “the market” in question? As Fama and French state, but do not elucidate, their study concerns US equity mutual funds. Even most active investors will agree that the US equity market is one of the most difficult ones in which to squeeze some advantage, particularly when the manager is constrained to a particular style (e.g. large value).A much more robust defense/rebuttal of the EMH would look at other markets. Of particular interest to me are riskier bonds and cross-border investments. Even further, a look at alternative investments (non-public funds) and styles (hedge funds or unconstrained managers) would be interesting. The problem with these other categories is that it is difficult to find the right model for what an efficient market would look like; it seems that the existence of any long-run positive returns in, for instance, a pairs-trading fund would be due to market inefficiencies.I’m no zealot for any particular point of view, but I’m glad for blogs such as yours to bring the discussion to life.

Posted by James | Report as abusive

james, excellent point, and let me add another (without, in any way, shape, or form challenging the core of our host’s position): to what extent did they subdivide a mutual fund’s results by recollection, for example, is that if you bought magellan the day peter lynch took the helm and sold magellan the day he retired, you way outperformed even after fairly significant fees. since then, of course, you haven’t….

Posted by howard | Report as abusive

This is the dirty little secret of the equities markets in the U.S. People who buy individual stocks or managed mutual funds will almost always under-perform the market over the time periods appropriate for equity investing. The entire financial media industry is built around promoting these vehicles, when in fact index funds are the only sensible approach. The fact that pension funds and school endowments speculate like this and squander money on ridiculous fees is scandalous.

Posted by BH | Report as abusive

Fama and French have just proved that hedge funds are efficient at draining talent from the pool of mutual fund managers.Take a marketplace of buyers and sellers of the equity of large corporations, then subject it to the most heavy regulations designed to clip the extremes away, relax regulations on competition to hire away the best talent, take private the best outliers, let the smart money fly to derivatives and alternative assets, and then *marvel* at the amazing discovery that the remaining husk of investment vehicles seem to be “efficient.”Yea, verily, yet another great research by F&F.

Posted by peatey | Report as abusive

Aggregate underperformance after fees is a tautology. If you aggregate all managers (which, after all, outnumber the number of stocks) and subtract all fees (which of course have to pay expenses) you get the market less fees.What is more interesting is a). risk-adjusted returns; and b). persistence of under/outperformance. There the studies are far more equivocal. From the many studies I’ve seen it appears that 1.) risk-adjusted outperformance is very rare; and 2.) it happens. Identifying talent is hard–most RFPs focus on the wrong things to try to find it. But it can be found, and consistent stock-selection (not market timing and not style selection) is the most dependable way to get it.But try to find a stock-picker who can prove his worth.

Posted by Douglas | Report as abusive

Someone should point Justin Fox to this paper and blog post.

Posted by Philip Rothman | Report as abusive

I found this line interesting: “We ignore funds that appear after September 2001 to avoid having lots of funds with short return histories.” Doesn’t that ignore a lot of funds with more positive returns while not factoring out the index funds that existed during that time?If everyone invests in index funds, instead of on fundamental value, won’t the stock market itself lose pricing information?Does the fact that I have made more money with foreign managed funds than in US index funds over a long time horizon mean anything here? Can this possibly hold true when it is a smart move is to hedge US inflation risk?

Posted by mattmc | Report as abusive

I think a lot of y’all are forgetting the Value Line effect and the early career of Warren Buffett, back when he was a stock picker rather than a conglomerateur.It’s pretty easy to argue that smart individual investors have enormous advantages over mutual fund managers. They are not accountable to slack-jawed investors on a quarterly basis, and don’t have to chase comparative performance. I’m quite willing to believe that they can beat the market.Of course, there are any number of fools who are also convinced that they can beat the market.

Posted by Joe S. | Report as abusive

Try one little experiment. You always hear how the market returns 7% a year. Try to find a fund that has returned 7% a year for 40 years, a time commensurate with one’s probable working life. There are only a handful, and they are index funds. Think you can do better. Well, quit your job, play the market full time, subscribe to Bloomberg and every other information and evaluation service and see where you get. Odds are you’ll do no better than a full time fund manager. After all, that’s what you’ll be. Sure, you might do a lot better, but you also might do a lot worse. In that, it’s no different than playing the lottery, but good luck in getting that 7%.

Posted by Anonymous | Report as abusive
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