Can mutual funds outperform the indexes?

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h3h8m3
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Can mutual funds outperform the indexes?

Post by h3h8m3 »

So, I know that this is just about the first rule of Bogleheads (other than not talking about Boglehead), but I am slightly struggling to overcome my in-grained assumptions that a professional fund manager can outperform the stock market.

http://fundresearch.fidelity.com/mutual ... /316071109

I look back at the funds I have in my portfolio, and look at the performance tabs, and most of them outperform their benchmarks. Question on this: Does this performance factor in the expense ratio of the fund? Meaning, where it says 24.79% in the last year versus 22.57% for the benchmark is that the actual difference, or do I need to take out the fund's expense ratio .92%?

Anyway, if you can help give me some evidence proving that I am not seeing what I think I see, that'd be super awesome. I don't want to get sucked into the magnetic pull of the anecdotal-luck-vortex that is above-market performance.

Thank you!
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Post by xerty24 »

Yes, performance is net of fees. Many poor/unlucky funds are closed or merged, causing selection bias where most funds appear to be "above average" historically and yet perform worse the average going forward.
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Post by livesoft »

Many funds have selected benchmarks that are inappropriate to their investing style and risk characteristics. We used to call such behavior "sand-bagging".

An example might be comparing a large cap value fund to the S&P500 index.

Another example might be comparing a foreign fund that contains a significant fraction of emerging markets stocks to the large-cap EAFE index of developed markets.
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Optimistic
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Post by Optimistic »

Hi h3h8m3,

When looking at the past performance of a mutual fund, expense ratio IS already taken into consideration. So, the fund with the 0.92% expense ratio and a 24.79% return last year truly did beat its benchmark and its 22.57% return. In fact, every year many actively managed mutual funds outperform their benchmark. The problem is there are many more actively managed mutual funds that underperform their benchmark each year. Moreover, it is not possible to know ahead of time which funds will outperform and which will underperform.

Many people assume that funds that have done well in the past will continue to do well in the future; however, this is not true. The best predictor of a funds future returns is not its past returns or its Morningstar rating. Instead, it is its cost (i.e. expense ratio).

Finally, think about this when trying to overcome your "ingrained assumptions that a professional fund manager can outperform the stock market." Active management is a zero-sum game. Whatever excessive returns (over what the market generates) your professional fund manager generates comes at the expense of some other professional fund manager. Moreover, you are often paying around 10 times more (not 10% more but 10 times more) for your active manager, who because of that cost, will likely fail to beat his benchmark.

Respectfully,
Optimistic
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Post by radionightster »

Boglehead and investment philosophy is amazing. It's incredibly simple, but at the same time it's completely unintuitive.
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Post by h3h8m3 »

Thanks to all three of you for your thoughtful responses.

Do you folks have any data to support that mutual funds are no more likely to outperform the market if they have done so in the past?

I know that casino operators have said that the best thing to ever happen to roulette tables was the invention of the big board showing previous results, and the fact that people see past trends and use that to predict future results. And I see how that exact same logic could be used here.

But with the roulette wheel we know it's strictly governed by the amount of randomness they can generate with that wheel. But with mutual funds there is human elements involved, including the skill of the fund manager, and the humans who are buying selling stocks outside of it of funds. So it seems like there COULD be a skill to outperforming the market.

Thanks!
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Post by UrbanMedic »

h3h8m3 wrote:Thanks to all three of you for your thoughtful responses.

Do you folks have any data to support that mutual funds are no more likely to outperform the market if they have done so in the past?

Just pick from this list:
http://scholar.google.com/scholar?hl=en ... =&as_vis=0
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Post by Avo »

There is a ton of research on this. Here is a recent paper by my favorite academic researcher on this topic, Russ Wermers:

http://www.rhsmith.umd.edu/faculty/rwer ... lished.pdf

Wermers et al conclude that, when benchmarked to the Fama-French 3-factor model, 1.7% of domestic equity funds display positive alpha (that is, beat the appropriate benchmark), 75% have zero alpha, and the rest have negative alpha.

This result is actually pretty favorable to active management, if you think you can avoid the 23.3% of funds with negative alpha.
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Re: Can mutual funds outperform the indexes?

Post by White Coat Investor »

h3h8m3 wrote:So, I know that this is just about the first rule of Bogleheads (other than not talking about Boglehead), but I am slightly struggling to overcome my in-grained assumptions that a professional fund manager can outperform the stock market.

http://fundresearch.fidelity.com/mutual ... /316071109

I look back at the funds I have in my portfolio, and look at the performance tabs, and most of them outperform their benchmarks. Question on this: Does this performance factor in the expense ratio of the fund? Meaning, where it says 24.79% in the last year versus 22.57% for the benchmark is that the actual difference, or do I need to take out the fund's expense ratio .92%?

Anyway, if you can help give me some evidence proving that I am not seeing what I think I see, that'd be super awesome. I don't want to get sucked into the magnetic pull of the anecdotal-luck-vortex that is above-market performance.

Thank you!
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Post by Winthorpe »

If you want the long, thorough, and comprehensive answer to your question, read "The Power of Passive Investing" by Rick Ferri. I'm currently reading this myself. Here he reviews the academic studies on this subject which shows that over just about any asset class, both domestic and international, there are genereally 2 losing active funds for each one that beats its benchmark (plus a whole lot more useful information).

http://www.amazon.com/Power-Passive-Inv ... 0470592206

Another favorite of mine on this topic is "The Great Mutual Fund Trap"

http://www.amazon.com/Great-Mutual-Fund ... 070&sr=1-1
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Post by Starting Investor »

• Bogle, J., The Implications of Style Analysis for Mutual Fund Performance Evaluation, Journal of Portfolio Management, Summer 1998.
• Brealey R., Stock prices, stock indexes and index funds, Bank of England Quarterly Bulletin: February 2000.
• Fama, E., Efficient Capital Markets II, Journal of Finance, 46, 1991.
• Horst, J.R. ter, Proefschrift: Longitudinal Analysis of Mutual Fund Performance, November 1998.
• Jensen, M.C., The Performance of Mutual Funds in the Period 1945-1964, The Journal of Finance, Volume 23, May 1968.
• Johnson, M. en Collins, L., When investing passively, do so actively, Journal of Accountancy, January 2000.
• Malkiel, B. G., Returns from Investing in Equity Mutual Funds 1971 to 1991, The Journal of Finance, Volume 50, Issue 2, June 1995, p 549 - 572.
• Malkiel, B. en Radisich A., The Growth of Index Funds and the Pricing of Equity Securities, The Journal of Portfolio Management, Winter 2001.
• Quigley, G. & Sinquefield, R., Performance of UK Equity unit trusts, Journal of Asset Management, Vol 1, Feb 2000.
• Sharpe, W.F., Mutual Fund Performance, Journal of Business, 39, 1966.
• Sharpe, W.F., The Arithmetic of Active Management, The Financial Analysts' Journal Vol 47, No 1, Jan/Feb 1991.
• Swedroe, L., Is it a search for the Holy Grail?, Journal of Accountancy, January 2000.
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Post by nisiprius »

I thought I had an actively-managed fund that was "outperforming the index." It was, specifically, Pax World Balanced Fund (PAXWX), a socially responsible fund, and it had about a 1% ratio. It's a nice illustration of a fairly common pattern, and a fairly common mental trap. I am going to play fair (or maybe cater to my own denial?) by picking a starting date that coincide with my first purchase of the fund, rather than by picking a date that would best illustrate the point I'm trying to make. So this is not an index-beats-active story, its an "active wasn't what it seemed" story.

The points I want to make are:
* Reward has to be considered in relation to risk
* Outperforming funds are often merely "magnified copies" of index funds
* The times when active funds do outperform tend to be short and rare; short, rare and lucrative, sometimes, but "short and rare" makes it very hard to distinguish skill from luck.

Image

Since Pax World Balanced Fund (PAXWX) is, as it name implies, a 60% stock / 40% bond balanced fund, I compare it to Vanguard Balanced Index Fund, which is a mix of 60% Vanguard Total Stock Market Index (VBINX) and 40% Vanguard Total Bond Market Index.

You see what's happening? Pax World invested differently from VBINX. At one point, for example, it had significant holdings in international stocks and in midcap stocks. I think it had high-tech circa 2000, high-tech stocks were and are a favorite of socially responsible investment funds.

It is almost a magnified copy of VBINX. It went up more than VBINX, and then it went down more than VBINX. More reward, yes, but more risk. And that's the point, because the important thing is not reward, it is reward in relation to risk. Anybody can increase reward, there's no trick to that: you just use leverage. Investing with borrowed money increases both reward and risk.

One measure of reward in relation to risk is the Sharpe ratio, which I don't really understand--I like graphs better than summary numbers--but for whatever it's worth, the 15-year Sharpe ratios reported by Vanguard are 0.43 for PAXWX and 0.41 for VBINX.

So in fact over the period shown the active fund actually did both outperform VBINX slightly and also showed a slightly higher Sharpe ratio. PAXWX owners have no complaints.

My point is the illusion during the time the stock market was going up. During that time, it appeared as if PAXWX was just kewl, significantly outperforming the index fund, not just by a little bit, by a lot. Even after expenses. Obviously the managers were geniuses. We now see that even though PAXWX did just fine, the outperformance was an illusion, and directly coupled with the fact that it had higher risk. Bigger gains in good times, bigger losses in bad. A scarier roller-coast ride to end up in almost the same place.

Now I don't think I want to go back and calculate my personal pattern of contributions. Anything I contributed in from 1993 to 1998 has grown more in PAXWX than it would have in VBINX. But anything contributed from 1999 to 2008, ahem, did not.

Finally, if you tinker with starting points you'll find that although there was some small, steady, worthwhile outperformance by PAXWX from 1999 to 2008--amounting to about 0.8% per year--making the fund look very nice during that time--the two big difference from VBINX occurred at two fairly specific points in time. PAXWX scored a big win circa 1998-9, then a big loss--bigger than average--in 2008-9.

The big win in 1998-9 counts in any period that includes it, so over the whole period from 1999 to 2008, the ten-year return number would have been buoyed by it. Is that illusion? Yes and no. Money in your pocket is money in your pocket. Someone who believes in active management might say that's what active managers do: score occasional jackpots for you. You parallel the index most of the time, but the manager really earns his money once a decade. The problem with that is that if outperformance occurs in rare bursts, the average mutual fund track record isn't long enough to tell if it's a consistent pattern and whether it is luck or skill.

And of course, as active funds grow, active managers find that they are effectively restricted to fewer and fewer stocks--don't want to get into that but it's a well-understood phenomenon--and tend to become more and more index-like. So another common pattern is the active fund that does really well in the early years before you ever heard of it and therefore couldn't have invested in it. By the time it start to make headlines and show up in 401(k)s, the star is fading. But the early performance continues to make the "since inception" and "10-year" returns look good.

As I say, PAXWX did fine and this isn't an index-beats-active story--you can of course jigger the starting date if you want a happy ending. It's a "be careful, things are often not what they seem" story.
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Post by smike »

Nispirius said
The points I want to make are:
* Reward has to be considered in relation to risk
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Post by JimHalpert »

Absolutely, of course a mutual fund can outperform its index.

The problem is identifying which funds will outperform beforehand.
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Re: Can mutual funds outperform the indexes?

Post by YDNAL »

h3h8m3 wrote:I look back at the funds I have in my portfolio, and look at the performance tabs, and most of them outperform their benchmarks.
H3,

This is the deal:
1) Often, the benchmark is inappropriate. This is a marketing ploy, mostly.
2) More often, the fund's holdings don't even come close to a benchmark. This is tracking error.

In the prospectus of any fund "in your portfolio" you can read that management often has leeway to invest in almost anything they see fit. Sometimes they pick the right stuff, sometimes not. The tracking error (#2) maybe beneficial today but not so tomorrow.
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h3h8m3
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Post by h3h8m3 »

Very interesting stuff. I appreciate all your feedback and information. I have a lot of reading to do!

Nisiprius, one thing that your story got me thinking about. Could an investor who wanted to reap the benefits of PAXWX simply have purchased a more risky set of unmanaged index funds to get the same results PAXWX did, with less expenses?

Thanks again for all your time and effort.
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Post by digit8 »

The first time I played poker, I got a straight flush. Two hands in a row.

Anyone can beat an index, just like anyone can win at cards.

Turn the cards every day, though, and the number of winners becomes progressively smaller.
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Post by nisiprius »

h3h8m3 wrote:Very interesting stuff. I appreciate all your feedback and information. I have a lot of reading to do!

Nisiprius, one thing that your story got me thinking about. Could an investor who wanted to reap the benefits of PAXWX simply have purchased a more risky set of unmanaged index funds to get the same results PAXWX did, with less expenses?

Thanks again for all your time and effort.
Literally, as I've presented it, since PAXWX did have a very slightly higher Sharpe ratio.

More generally, I think the answer is yes. And I think the answer is also that you could simply have used a larger allocation of an ordinary total stock market index fund.

(PAXWX is weird, by the way, because of being "socially responsible" but I don't want to go down that sidetrack).

That is, the question that always needs to be asked--for which I don't have handy tools to find quick answers--is "Say my portfolio is 60% actively managed stock fund and 40% bonds. Say the stock fund has higher return but also higher risk than Vanguard Total Stock Market Index Fund (VTSMX). Since VTSMX has lower risk I can safely use more of it. If I replace the active fund with the index fund but hold portfolio risk constant by using more of it, is my return better or worse?"

That's a question for the portfolio construction mavens.

I'm guessing the answer is that that's what the Sharpe ratio is supposed to tell you, and the usual answer is "about the same, except for extra costs of the active fund... and hard to prove either way, due to the luck and the breaks over any given time period."

I don't know the answer, but I'm sure the right question is always "how does that compare to just changing my stock allocation?" In the case of adding small value, the answer is supposed to be that because of lack of correlation, the risk isn't additive... but someone else can explain that.
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Post by Oneanddone »

Here's what I see as one basic problem with the people who say that funds can't beat a benchmark. They use hindsite to change the target.

Jim manages XYZ fund. He has a decent amount of latitude in picking stocks. XYZ fund is mostly large cap U.S. stocks and Jim strives to beat the S&P 500. Jim thinks that he sees some smaller foreign companies that are really poised to go up in value. He turns out to be correct and XYZ beats the S&P 500 by 3%. His fund returned 17% while the S&P returned 14%.

The naysayers will instead of saying that Jim beat his S&P 500 benchmark, it would have been more appropriate to compare him to 80% S&P 500 and 20% emerging market. By doing it that way, they are completely ignoring that it was the manager's decision to put money into emerging markets in the first place. They will point out that an 80/20 mix into those two indicies would have returned 17.3%, so Jim underperformed.

If Jim would have stuck with all large caps, he would have been up hypothetically, 14.5% and would have been considered to outperform, but because he chose to go with some emerging markets, he actually got 17% and because of this, naysayers will put him back in the underperforming category. It makes no sense.

Of course, you can't pick out Jim in advance so you might as well go with a low cost index.
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Post by HomerJ »

nisiprius wrote:I thought I had an actively-managed fund that was "outperforming the index." It was, specifically, Pax World Balanced Fund (PAXWX), a socially responsible fund, and it had about a 1% ratio. It's a nice illustration of a fairly common pattern, and a fairly common mental trap. I am going to play fair (or maybe cater to my own denial?) by picking a starting date that coincide with my first purchase of the fund, rather than by picking a date that would best illustrate the point I'm trying to make. So this is not an index-beats-active story, its an "active wasn't what it seemed" story.

The points I want to make are:
* Reward has to be considered in relation to risk
* Outperforming funds are often merely "magnified copies" of index funds
* The times when active funds do outperform tend to be short and rare; short, rare and lucrative, sometimes, but "short and rare" makes it very hard to distinguish skill from luck.

Image

Since Pax World Balanced Fund (PAXWX) is, as it name implies, a 60% stock / 40% bond balanced fund, I compare it to Vanguard Balanced Index Fund, which is a mix of 60% Vanguard Total Stock Market Index (VBINX) and 40% Vanguard Total Bond Market Index.

You see what's happening? Pax World invested differently from VBINX. At one point, for example, it had significant holdings in international stocks and in midcap stocks. I think it had high-tech circa 2000, high-tech stocks were and are a favorite of socially responsible investment funds.

It is almost a magnified copy of VBINX. It went up more than VBINX, and then it went down more than VBINX. More reward, yes, but more risk. And that's the point, because the important thing is not reward, it is reward in relation to risk. Anybody can increase reward, there's no trick to that: you just use leverage. Investing with borrowed money increases both reward and risk.

One measure of reward in relation to risk is the Sharpe ratio, which I don't really understand--I like graphs better than summary numbers--but for whatever it's worth, the 15-year Sharpe ratios reported by Vanguard are 0.43 for PAXWX and 0.41 for VBINX.

So in fact over the period shown the active fund actually did both outperform VBINX slightly and also showed a slightly higher Sharpe ratio. PAXWX owners have no complaints.

My point is the illusion during the time the stock market was going up. During that time, it appeared as if PAXWX was just kewl, significantly outperforming the index fund, not just by a little bit, by a lot. Even after expenses. Obviously the managers were geniuses. We now see that even though PAXWX did just fine, the outperformance was an illusion, and directly coupled with the fact that it had higher risk. Bigger gains in good times, bigger losses in bad. A scarier roller-coast ride to end up in almost the same place.

Now I don't think I want to go back and calculate my personal pattern of contributions. Anything I contributed in from 1993 to 1998 has grown more in PAXWX than it would have in VBINX. But anything contributed from 1999 to 2008, ahem, did not.

Finally, if you tinker with starting points you'll find that although there was some small, steady, worthwhile outperformance by PAXWX from 1999 to 2008--amounting to about 0.8% per year--making the fund look very nice during that time--the two big difference from VBINX occurred at two fairly specific points in time. PAXWX scored a big win circa 1998-9, then a big loss--bigger than average--in 2008-9.

The big win in 1998-9 counts in any period that includes it, so over the whole period from 1999 to 2008, the ten-year return number would have been buoyed by it. Is that illusion? Yes and no. Money in your pocket is money in your pocket. Someone who believes in active management might say that's what active managers do: score occasional jackpots for you. You parallel the index most of the time, but the manager really earns his money once a decade. The problem with that is that if outperformance occurs in rare bursts, the average mutual fund track record isn't long enough to tell if it's a consistent pattern and whether it is luck or skill.

And of course, as active funds grow, active managers find that they are effectively restricted to fewer and fewer stocks--don't want to get into that but it's a well-understood phenomenon--and tend to become more and more index-like. So another common pattern is the active fund that does really well in the early years before you ever heard of it and therefore couldn't have invested in it. By the time it start to make headlines and show up in 401(k)s, the star is fading. But the early performance continues to make the "since inception" and "10-year" returns look good.

As I say, PAXWX did fine and this isn't an index-beats-active story--you can of course jigger the starting date if you want a happy ending. It's a "be careful, things are often not what they seem" story.
Here's an additional lesson...

Anyone who was checking out funds in 2000 probably looked at the past results of PAXWX and said "Man, this fund is trouncing the corresponding index fund!". Yet if you invested in it in 2000 and held to today, you made less money than if you had bought the index.

Past performance does not predict future results.
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Post by gt4715b »

Oneanddone wrote:Here's what I see as one basic problem with the people who say that funds can't beat a benchmark. They use hindsite to change the target.

Jim manages XYZ fund. He has a decent amount of latitude in picking stocks. XYZ fund is mostly large cap U.S. stocks and Jim strives to beat the S&P 500. Jim thinks that he sees some smaller foreign companies that are really poised to go up in value. He turns out to be correct and XYZ beats the S&P 500 by 3%. His fund returned 17% while the S&P returned 14%.

The naysayers will instead of saying that Jim beat his S&P 500 benchmark, it would have been more appropriate to compare him to 80% S&P 500 and 20% emerging market. By doing it that way, they are completely ignoring that it was the manager's decision to put money into emerging markets in the first place. They will point out that an 80/20 mix into those two indicies would have returned 17.3%, so Jim underperformed.

If Jim would have stuck with all large caps, he would have been up hypothetically, 14.5% and would have been considered to outperform, but because he chose to go with some emerging markets, he actually got 17% and because of this, naysayers will put him back in the underperforming category. It makes no sense.

Of course, you can't pick out Jim in advance so you might as well go with a low cost index.
It's because the alpha that people talk about is a measure of someone's ability to pick outperforming individual stocks, so you have to select the right benchmark to be able to do this. In other words, your hypothetical manager hasn't demonstrated any ability to pick individual stocks, just the ability to predict that foreign stocks would outperform US stocks. So he in fact wasted his skill because he would have been better off using US stock and foreign stock indices to act on his foreign stock prediction.

However, I do have the basic question as you, that is, are there studies that try to determine whether people have ability at generating "asset class" alpha, being able to tell which asset class are going to outperform.
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Re: Can mutual funds outperform the indexes?

Post by YDNAL »

Oneanddone wrote:Jim manages XYZ fund. He has a decent amount of latitude in picking stocks. XYZ fund is mostly large cap U.S. stocks and Jim strives to beat the S&P 500. Jim thinks that he sees some smaller foreign companies that are really poised to go up in value. He turns out to be correct and XYZ beats the S&P 500 by 3%. His fund returned 17% while the S&P returned 14%.

The naysayers will instead of saying that Jim beat his S&P 500 benchmark, it would have been more appropriate to compare him to 80% S&P 500 and 20% emerging market. By doing it that way, they are completely ignoring that it was the manager's decision to put money into emerging markets in the first place. They will point out that an 80/20 mix into those two indicies would have returned 17.3%, so Jim underperformed.
One,

Why benchmark/compare in the first place?
  • Since Jim can hold whatever Jim feels like, comparing to an inappropriate specific benchmark is nothing but a waste of time.
  • It would be more impressive (logical?), if Jim picks S&P 500 companies to beat the index.
For instance, without disclosing my method, I'm thinking to select 50 stocks, post my choices here, and prove to everyone MY skills in picking S&P 500 stocks to beat the S&P 500 Index. :lol:
9 Consumer Discretionary
4 Consumer Staples
3 Energy
9 Financials
5 Healthcare
6 Industrials
7 IT
3 Materials
1 Telecomm
3 Utilities
50 Total Stocks

NAH!.. waste of time.

Edit: to delete the huge list of all S&P 500 companies.
Last edited by YDNAL on Wed Mar 09, 2011 12:59 pm, edited 1 time in total.
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Post by natureexplorer »

Are there index funds that have outperformed their respective indices over several consecutive years?
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Outperforming the index ?

Post by Taylor Larimore »

Hi natureexplorer:
natureexplorer wrote:Are there index funds that have outperformed their respective indices over several consecutive years?
I suppose there are several. However, outperforming the index is considered a failure in the index world. The goal of an index manager is to "match" the index less expenses.

I misunderstood you post and made this first post in answer to your question. I'll post it anyway.
Yes. The Legg Mason Value Trust (LMVTX) managed by Bill Miller beat the S&P 500 Index fund for a record 15 years from 1951 through 2005. Mr. Miller was considered by many to be the best fund manager in the business.

Mr. Miller is still the fund manager. Legg Mason Value Trust is currently in the bottom 1% of all funds in its category during the past 10 years.

Past performance does not forecast future performance.
Last edited by Taylor Larimore on Tue Mar 08, 2011 3:27 pm, edited 2 times in total.
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Post by golfallday »

Read Larry Swedroe's "The Only Guide To A Winning Investment Strategy You'll Ever Need". He answers your concerns in the first 6 chapters. The rest of the book is great, too.

My favorite line Mr Swedroe's book....."diversification is always working for you; sometimes you like the results...sometimes you don't."

-----------------------
Amateurs built Noah's Ark.....experts built The Titanic.

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Last edited by golfallday on Tue Mar 08, 2011 3:32 pm, edited 1 time in total.
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Post by natureexplorer »

VIIIX (the Institutional Plus shares of the Vanguard S&P 500 index fund) outperformed the S&P 500 index in every single year from 2002-2010.
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Post by pkcrafter »

Oneanddone wrote:Here's what I see as one basic problem with the people who say that funds can't beat a benchmark. They use hindsite to change the target.

Jim manages XYZ fund. He has a decent amount of latitude in picking stocks. XYZ fund is mostly large cap U.S. stocks and Jim strives to beat the S&P 500. Jim thinks that he sees some smaller foreign companies that are really poised to go up in value. He turns out to be correct and XYZ beats the S&P 500 by 3%. His fund returned 17% while the S&P returned 14%.

The naysayers will instead of saying that Jim beat his S&P 500 benchmark, it would have been more appropriate to compare him to 80% S&P 500 and 20% emerging market. By doing it that way, they are completely ignoring that it was the manager's decision to put money into emerging markets in the first place. They will point out that an 80/20 mix into those two indicies would have returned 17.3%, so Jim underperformed.

If Jim would have stuck with all large caps, he would have been up hypothetically, 14.5% and would have been considered to outperform, but because he chose to go with some emerging markets, he actually got 17% and because of this, naysayers will put him back in the underperforming category. It makes no sense.

Of course, you can't pick out Jim in advance so you might as well go with a low cost index.
Did Jim provide alpha? No.



Paul
Last edited by pkcrafter on Tue Mar 08, 2011 3:54 pm, edited 1 time in total.
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Post by radionightster »

Oneanddone wrote:Here's what I see as one basic problem with the people who say that funds can't beat a benchmark. They use hindsite to change the target.

Jim manages XYZ fund. He has a decent amount of latitude in picking stocks. XYZ fund is mostly large cap U.S. stocks and Jim strives to beat the S&P 500. Jim thinks that he sees some smaller foreign companies that are really poised to go up in value. He turns out to be correct and XYZ beats the S&P 500 by 3%. His fund returned 17% while the S&P returned 14%.

The naysayers will instead of saying that Jim beat his S&P 500 benchmark, it would have been more appropriate to compare him to 80% S&P 500 and 20% emerging market. By doing it that way, they are completely ignoring that it was the manager's decision to put money into emerging markets in the first place. They will point out that an 80/20 mix into those two indicies would have returned 17.3%, so Jim underperformed.

If Jim would have stuck with all large caps, he would have been up hypothetically, 14.5% and would have been considered to outperform, but because he chose to go with some emerging markets, he actually got 17% and because of this, naysayers will put him back in the underperforming category. It makes no sense.

Of course, you can't pick out Jim in advance so you might as well go with a low cost index.
But, since Jim went 80/20, didn't he expose the portfolio to more risk? He had just as much (if not more) of a chance of doing way worse than the index, becuase of this increased risk. There may be overlap now between Jim's 80/20 and the S&P500, but it's just that - overlap - they are no longer comparing apples to apples.

So yes, Jim beat the "benchmark", but it's not really comparing the same things. That's like comparing SCV to TSM. They have different risk, returns, and aren't the same thing, despite whatever overlap they may have.
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Post by pkcrafter »

rrosenkoetter wrote:
nisiprius wrote:I thought I had an actively-managed fund that was "outperforming the index." It was, specifically, Pax World Balanced Fund (PAXWX), a socially responsible fund, and it had about a 1% ratio. It's a nice illustration of a fairly common pattern, and a fairly common mental trap. I am going to play fair (or maybe cater to my own denial?) by picking a starting date that coincide with my first purchase of the fund, rather than by picking a date that would best illustrate the point I'm trying to make. So this is not an index-beats-active story, its an "active wasn't what it seemed" story.

The points I want to make are:
* Reward has to be considered in relation to risk
* Outperforming funds are often merely "magnified copies" of index funds
* The times when active funds do outperform tend to be short and rare; short, rare and lucrative, sometimes, but "short and rare" makes it very hard to distinguish skill from luck.

Image

Since Pax World Balanced Fund (PAXWX) is, as it name implies, a 60% stock / 40% bond balanced fund, I compare it to Vanguard Balanced Index Fund, which is a mix of 60% Vanguard Total Stock Market Index (VBINX) and 40% Vanguard Total Bond Market Index.

You see what's happening? Pax World invested differently from VBINX. At one point, for example, it had significant holdings in international stocks and in midcap stocks. I think it had high-tech circa 2000, high-tech stocks were and are a favorite of socially responsible investment funds.

It is almost a magnified copy of VBINX. It went up more than VBINX, and then it went down more than VBINX. More reward, yes, but more risk. And that's the point, because the important thing is not reward, it is reward in relation to risk. Anybody can increase reward, there's no trick to that: you just use leverage. Investing with borrowed money increases both reward and risk.

One measure of reward in relation to risk is the Sharpe ratio, which I don't really understand--I like graphs better than summary numbers--but for whatever it's worth, the 15-year Sharpe ratios reported by Vanguard are 0.43 for PAXWX and 0.41 for VBINX.

So in fact over the period shown the active fund actually did both outperform VBINX slightly and also showed a slightly higher Sharpe ratio. PAXWX owners have no complaints.

My point is the illusion during the time the stock market was going up. During that time, it appeared as if PAXWX was just kewl, significantly outperforming the index fund, not just by a little bit, by a lot. Even after expenses. Obviously the managers were geniuses. We now see that even though PAXWX did just fine, the outperformance was an illusion, and directly coupled with the fact that it had higher risk. Bigger gains in good times, bigger losses in bad. A scarier roller-coast ride to end up in almost the same place.

Now I don't think I want to go back and calculate my personal pattern of contributions. Anything I contributed in from 1993 to 1998 has grown more in PAXWX than it would have in VBINX. But anything contributed from 1999 to 2008, ahem, did not.

Finally, if you tinker with starting points you'll find that although there was some small, steady, worthwhile outperformance by PAXWX from 1999 to 2008--amounting to about 0.8% per year--making the fund look very nice during that time--the two big difference from VBINX occurred at two fairly specific points in time. PAXWX scored a big win circa 1998-9, then a big loss--bigger than average--in 2008-9.

The big win in 1998-9 counts in any period that includes it, so over the whole period from 1999 to 2008, the ten-year return number would have been buoyed by it. Is that illusion? Yes and no. Money in your pocket is money in your pocket. Someone who believes in active management might say that's what active managers do: score occasional jackpots for you. You parallel the index most of the time, but the manager really earns his money once a decade. The problem with that is that if outperformance occurs in rare bursts, the average mutual fund track record isn't long enough to tell if it's a consistent pattern and whether it is luck or skill.

And of course, as active funds grow, active managers find that they are effectively restricted to fewer and fewer stocks--don't want to get into that but it's a well-understood phenomenon--and tend to become more and more index-like. So another common pattern is the active fund that does really well in the early years before you ever heard of it and therefore couldn't have invested in it. By the time it start to make headlines and show up in 401(k)s, the star is fading. But the early performance continues to make the "since inception" and "10-year" returns look good.

As I say, PAXWX did fine and this isn't an index-beats-active story--you can of course jigger the starting date if you want a happy ending. It's a "be careful, things are often not what they seem" story.
Here's an additional lesson...

Anyone who was checking out funds in 2000 probably looked at the past results of PAXWX and said "Man, this fund is trouncing the corresponding index fund!". Yet if you invested in it in 2000 and held to today, you made less money than if you had bought the index.

Past performance does not predict future results.
I don't know how we got on to PAXWX, but it is 73% stock including 17% international. It does have a good 15 year track record, but in every time period since then it is in the 70-80 percentile compared to a 60/40 benchmark.


Paul
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Post by careytilden »

Oneanddone wrote:Here's what I see as one basic problem with the people who say that funds can't beat a benchmark. They use hindsite to change the target.

Jim manages XYZ fund. He has a decent amount of latitude in picking stocks. XYZ fund is mostly large cap U.S. stocks and Jim strives to beat the S&P 500. Jim thinks that he sees some smaller foreign companies that are really poised to go up in value. He turns out to be correct and XYZ beats the S&P 500 by 3%. His fund returned 17% while the S&P returned 14%.

The naysayers will instead of saying that Jim beat his S&P 500 benchmark, it would have been more appropriate to compare him to 80% S&P 500 and 20% emerging market. By doing it that way, they are completely ignoring that it was the manager's decision to put money into emerging markets in the first place. They will point out that an 80/20 mix into those two indicies would have returned 17.3%, so Jim underperformed.

If Jim would have stuck with all large caps, he would have been up hypothetically, 14.5% and would have been considered to outperform, but because he chose to go with some emerging markets, he actually got 17% and because of this, naysayers will put him back in the underperforming category. It makes no sense.

Of course, you can't pick out Jim in advance so you might as well go with a low cost index.
My take on this, after reading the other replies, is that an honestly run fund should have an expected level of risk, selected ahead of time, and the fund managers should strive to maintain that level of risk. Not only would this make it clear what investors should expect, but it would make choosing an appropriate benchmark possible in advance.

I don't know how many funds are actually run this way, but it seems like it should be a very basic tenet of good fund management.
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Post by hpygolky »

livesoft wrote:Many funds have selected benchmarks that are inappropriate to their investing style and risk characteristics. We used to call such behavior "sand-bagging".

An example might be comparing a large cap value fund to the S&P500 index.

Another example might be comparing a foreign fund that contains a significant fraction of emerging markets stocks to the large-cap EAFE index of developed markets.
This is a problem with indexing and not active management - and a pretty silly argument for indexing in my opinion.

For those who invest in actively managed funds, isn't that what they are paying for? If the manager of an international fund avoids or underweights a country as a result political reasons, raising interest rates, etc. why is it that because the index fund has more exposure to that country the active fund is penalized in your eyes?

There are many actively managed international funds that have much better market performance than the MSCI EAFE. I guess because those actively managed funds didn't own BP or didn't ride it to the bottom, they should not be allowed to compare their performance to the EAFE (in which BP was a top holding).

I can understand that you shouldn't compare an emerging market fund to a developing market fund. But to say a fund like Oakmark International should not be compared to the EAFE because it has a value tilt or the median market cap is lower, is ridiculous.
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Re: Can mutual funds outperform the indexes?

Post by YDNAL »

hpygolky wrote:For those who invest in actively managed funds, isn't that what they are paying for? If the manager of an international fund avoids or underweights a country as a result political reasons, raising interest rates, etc. why is it that because the index fund has more exposure to that country the active fund is penalized in your eyes?
You are right, active management should have flexibility to add/subtract from an Index as (s)he sees fit. This type of strategy should not be construed to be using an inappropriate index. That said, once the manager ventures out of the universe of holdings represented in the index.... apples and bananas.
hpygolky wrote:There are many actively managed international funds that have much better market performance than the MSCI EAFE. I guess because those actively managed funds didn't own BP or didn't ride it to the bottom, they should not be allowed to compare their performance to the EAFE (in which BP was a top holding).
See first response.
hpygolky wrote:I can understand that you shouldn't compare an emerging market fund to a developing market fund. But to say a fund like Oakmark International should not be compared to the EAFE because it has a value tilt or the median market cap is lower, is ridiculous.
See first response.
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Post by pkcrafter »

careytilden wrote:
Oneanddone wrote:Here's what I see as one basic problem with the people who say that funds can't beat a benchmark. They use hindsite to change the target.

Jim manages XYZ fund. He has a decent amount of latitude in picking stocks. XYZ fund is mostly large cap U.S. stocks and Jim strives to beat the S&P 500. Jim thinks that he sees some smaller foreign companies that are really poised to go up in value. He turns out to be correct and XYZ beats the S&P 500 by 3%. His fund returned 17% while the S&P returned 14%.

The naysayers will instead of saying that Jim beat his S&P 500 benchmark, it would have been more appropriate to compare him to 80% S&P 500 and 20% emerging market. By doing it that way, they are completely ignoring that it was the manager's decision to put money into emerging markets in the first place. They will point out that an 80/20 mix into those two indicies would have returned 17.3%, so Jim underperformed.

If Jim would have stuck with all large caps, he would have been up hypothetically, 14.5% and would have been considered to outperform, but because he chose to go with some emerging markets, he actually got 17% and because of this, naysayers will put him back in the underperforming category. It makes no sense.

Of course, you can't pick out Jim in advance so you might as well go with a low cost index.
My take on this, after reading the other replies, is that an honestly run fund should have an expected level of risk, selected ahead of time, and the fund managers should strive to maintain that level of risk. Not only would this make it clear what investors should expect, but it would make choosing an appropriate benchmark possible in advance.

I don't know how many funds are actually run this way, but it seems like it should be a very basic tenet of good fund management.
Since an active manager's goal is to outperform something, they must deviate from their category benchmark. Those that don't are simply closet indexers. Any fund mangers worth considering must take more risk to overcome the costs and produce high returns, and usually style and size classifications will vary.

Paul
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Post by pkcrafter »

hpygolky wrote:
livesoft wrote:Many funds have selected benchmarks that are inappropriate to their investing style and risk characteristics. We used to call such behavior "sand-bagging".

An example might be comparing a large cap value fund to the S&P500 index.

Another example might be comparing a foreign fund that contains a significant fraction of emerging markets stocks to the large-cap EAFE index of developed markets.
This is a problem with indexing and not active management - and a pretty silly argument for indexing in my opinion.

You have it backwards--this is a problem with active funds. Index funds will consistently perform in their category. Diversification is important and if you hold 8-10 active funds you cannot control diversification; it's going to vary from year to year. It is, in fact, one major reason why I don't like active funds. I like my portfolio to remain diversified in the asset classes I'm selected.

For those who invest in actively managed funds, isn't that what they are paying for? If the manager of an international fund avoids or underweights a country as a result political reasons, raising interest rates, etc. why is it that because the index fund has more exposure to that country the active fund is penalized in your eyes?

You are right, that's what investors in active funds are paying for. They trust the manager is smart enough to make the right bets. Only problem is the vast amount of research and data on this says they can't do it consistently.

There are many actively managed international funds that have much better market performance than the MSCI EAFE. I guess because those actively managed funds didn't own BP or didn't ride it to the bottom, they should not be allowed to compare their performance to the EAFE (in which BP was a top holding).

You can always find some active funds that are outperforming the index, in fact almost half should be outperforming at any given time. But if you look at long term performance, index funds clearly outperform because of lower costs and the avoidance of problems that active funds encounter. Active funds simply do not show persistence in the top half of performance.

I can understand that you shouldn't compare an emerging market fund to a developing market fund. But to say a fund like Oakmark International should not be compared to the EAFE because it has a value tilt or the median market cap is lower, is ridiculous.

Oakmark has performed very well, so disagreement there. The question now is how much longer will it continue to outperform?

Indexing is certainly not intuitive to the average investor. You should do the reading and then decide on what is a better approach for you. Most investors do use active funds, but the majority of them simple are clueless in any investing fundamentals. Of those who do know what they are doing, the majority still selects active funds but they lack the necessary discipline to do well. There are some very good active fund investors and they know the odds are against them, but they are very disciplined and take a long term view.


Paul
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Post by jmbkb4 »

answer to question: Of course!

AGTHX has outperformed the market by 1-2% annualized per year since 1972.

Many on here will dismiss that but I think it's a significant period of time.

(I know it's in the past.)
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Post by pkcrafter »

AGTHX does have a good historical record--up until 5 years ago. Now it is average at best, and M* lists it's performance as below average. Looks like it's turned into a closet index fund.


Paul
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Post by jmbkb4 »

I agree. Just using an example. Even incorporating last 5 years, still has great long-term track record.

I unfortunately own some of this mutual fund and have made too much in it to want to pay the CG on it.
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Post by DTSC »

jmbkb4 wrote:answer to question: Of course!

AGTHX has outperformed the market by 1-2% annualized per year since 1972.

Many on here will dismiss that but I think it's a significant period of time.

(I know it's in the past.)

Darn it! I should have put all my money into it back in 1972!
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Post by jmbkb4 »

that's why i'm here.
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Post by fluffyistaken »

Many actively managed investments will beat the index in any given year. Some will do so over many years. But an average dollar-weighted actively managed investment will never beat the index operating in the same market. Simple proof...

Let's say the market return is M%. The "market" could be the stock market, the bond market, both, just US, EAFE, emerging, global, some segment like the S&P500, etc. Only thing that matters is that we're talking about indexers and active managers operating on the same set of securities which we call the "market".

The market consists of I dollars in indexed investments and A dollars in actively managed investments. The I dollars will return M% before expenses assuming index managers are competent (e.g. Vanguard). The A dollars will return X% before expenses. Solving for X we find that it must also be equal to M% because the return of indexers before expenses + return of actively managed before expenses must combine to equal the total market return:
I*M + A*X = (I + A)*M
which means that X = M

Since the pre-expense returns of indexed and actively managed investments (in the same market) are identical and since actively managed investments always carry higher expenses (if not always then in 99+% of the cases), it means that an average indexed investment will always beat an average actively managed one. All "averages" are dollar-weighted here.
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Post by Jacobkg »

Can they? Yes
Will some? Yes
Which ones? I don't know
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Post by no_name »

YES.

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ect....
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Post by Rick Ferri »

A buy, hold and rebalance strategy outperforms a buy, hold and do nothing strategy, a.k.a. the market indexes. Rebalancing historically adds about 0.5% annually per decade on average, and it has added about 1.5% annually during the last decade. So, we can say that a well-diversified portfolio of low-cost index funds that's rebalanced annually BEATS THE MARKETS!

Low-fees, tax-efficiency, and beats the markets...what more could we ask for?

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Post by Oneanddone »

pkcrafter wrote:
Oneanddone wrote:Here's what I see as one basic problem with the people who say that funds can't beat a benchmark. They use hindsite to change the target.

Jim manages XYZ fund. He has a decent amount of latitude in picking stocks. XYZ fund is mostly large cap U.S. stocks and Jim strives to beat the S&P 500. Jim thinks that he sees some smaller foreign companies that are really poised to go up in value. He turns out to be correct and XYZ beats the S&P 500 by 3%. His fund returned 17% while the S&P returned 14%.

The naysayers will instead of saying that Jim beat his S&P 500 benchmark, it would have been more appropriate to compare him to 80% S&P 500 and 20% emerging market. By doing it that way, they are completely ignoring that it was the manager's decision to put money into emerging markets in the first place. They will point out that an 80/20 mix into those two indicies would have returned 17.3%, so Jim underperformed.

If Jim would have stuck with all large caps, he would have been up hypothetically, 14.5% and would have been considered to outperform, but because he chose to go with some emerging markets, he actually got 17% and because of this, naysayers will put him back in the underperforming category. It makes no sense.

Of course, you can't pick out Jim in advance so you might as well go with a low cost index.
Did Jim provide alpha? No.



Paul
The question wasn't whether the manager provided alpha. The question was simply whether one can outperform. I'm not commenting about whether it is luck or skill or whether it is more or less risk and I'm certainly not saying that one should use active funds.* I'm saying that a manager can outperform. Nothing more should be read into that statement.

*My personal opinion is that active vs. index is about the least important decision that one can make and it's probably pretty easy to rattle off 10 things of more importance in determining one's future wealth.
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Post by careytilden »

pkcrafter wrote:
careytilden wrote:
Oneanddone wrote:Here's what I see as one basic problem with the people who say that funds can't beat a benchmark. They use hindsite to change the target.

Jim manages XYZ fund. He has a decent amount of latitude in picking stocks. XYZ fund is mostly large cap U.S. stocks and Jim strives to beat the S&P 500. Jim thinks that he sees some smaller foreign companies that are really poised to go up in value. He turns out to be correct and XYZ beats the S&P 500 by 3%. His fund returned 17% while the S&P returned 14%.

The naysayers will instead of saying that Jim beat his S&P 500 benchmark, it would have been more appropriate to compare him to 80% S&P 500 and 20% emerging market. By doing it that way, they are completely ignoring that it was the manager's decision to put money into emerging markets in the first place. They will point out that an 80/20 mix into those two indicies would have returned 17.3%, so Jim underperformed.

If Jim would have stuck with all large caps, he would have been up hypothetically, 14.5% and would have been considered to outperform, but because he chose to go with some emerging markets, he actually got 17% and because of this, naysayers will put him back in the underperforming category. It makes no sense.

Of course, you can't pick out Jim in advance so you might as well go with a low cost index.
My take on this, after reading the other replies, is that an honestly run fund should have an expected level of risk, selected ahead of time, and the fund managers should strive to maintain that level of risk. Not only would this make it clear what investors should expect, but it would make choosing an appropriate benchmark possible in advance.

I don't know how many funds are actually run this way, but it seems like it should be a very basic tenet of good fund management.
Since an active manager's goal is to outperform something, they must deviate from their category benchmark. Those that don't are simply closet indexers. Any fund mangers worth considering must take more risk to overcome the costs and produce high returns, and usually style and size classifications will vary.

Paul
Sure, I suppose the whole point of active management is to find investments that are special and skew the fund towards those. But shouldn't active managers at least try to control the level of risk they're taking? There's still a lot of room for active selection within a pre-defined risk level.
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