Login
Password

Forgot your password?

Mutual Fund Performance: Skill or Luck

By Edited Sep 23, 2016 2 3
Stocks
Credit: 3dprint.com

Security Market Line

Burton Malkiel, a Princeton Economics professor, decided to study the performance of mutual funds and how their returns stacked up against theoretical returns overall for a ten-year period. The returns that he used for comparison were generated using the CAPM, that is the capital asset pricing model. This theoretical model predicts what returns should be after taking into consideration an assets level of risk. For example: each stock has a verging degree of inherent risk that cannot be eliminated by diversification. The CAPM estimates what each stock should earn, or the expected return based on this measurement of risk, the current risk-free rate of return, and the overall market returns. This inherent, unavoidable and non diversifiable risk is measured by Beta. By definition Beta is a measure of covariability with the overall market, therefore the Beta of the overall market is equal to 1. The graphical representation of this relationship is called the securities market line (SML). The SML intersects the vertical axis at the risk-free rate and cuts through the market Beta 1. In theory all stock should plot on the SML indicating their returns are exactly what they should be for their level of risk or Beta. However, at times you may see a stock that is temporarily priced too low according to it’s level of risk. These stocks that cost less than they are worth, based on their actual performance, will plot above the SML. Stocks that yield less than they should will plot below the SML. 

Efficient Markets

In an efficient market investors will quickly exploit these opportunities. Under-priced stocks will quickly be bid higher as investors recognize this miss pricing and this activity will push returns back to those predicted by the SML. The reverse happens for over-priced stocks. Malkiel used this concept to test mutual fund performance. Since mutual funds are managed by financial experts, one might expect their superior ability to find undervalued stocks would enable them to create a portfolio that consistently plots above the SML. Their expertise is to choose correctly many stocks that will over perform given the inherent market risk. They hope their skill will guide them to create funds that will over perform and yield returns that are above average. Malkiel tested this assumption. He forecasted what a funds manager should be for its overall risk using the CAPM. Then he compared these forecasts with the real returns of these fund managers. Oddly Malkiel’s findings were the opposite of what you would expect. He found that most of the mutual fund managers in his sample under performed. They actually earned lower returns than what they should have for their level of risk measured by Beta.

CAPM
Credit: blog.suatatan.com

Research

In one of his tests Malkiel focused on the returns for 239 equity mutual funds over the period from 1982-1991. He calculated the average return and Beta for each fund, and then plotted these points against the security market line, using the S&P 500 as a market proxy. If the market is efficient and the CAPM is true, then we would expect the sample of mutual funds to cluster around the SML. If the market is inefficient than we would expect mutual funds to out-perform the security market line. This out-performance is a result of the funds advantage in finding under valued stocks. This advantage stems from the fact the mutual funds have rich data resources and that they higher the smartest finance graduates.

Results

In the actual results, Malkiel found that the average fund lies 2% below the SML. In other words, it generates a return that is 2% less than the CAPM suggests it should be given its systematic risk. Malkiel divided his full sample from 1970-1980 in half. He considered a hypothetical investor standing in 1980 wanting to invest in mutual funds, which should he choose? If historical out performance is due to skill, then he should invest in the best historical performers. Malkiel looked at the top 20 performers of the 1970’s. The average return from the top 20 mutual funds for the period 1970-1980 was 19.01%. Which is huge! It is higher than the average for all funds in the same period, 9.74%. And larger than the S&P 500 index, 8.45%. Average top 20 funds from 1980-1990 was 10.87%. The average return from all funds, in the same period, was 11.56% and the average return for the S&P 500 was 13.87%. How did our representative investor do over the 1980’s after investing equally in the top 20 funds? The funds earned an average of 10.87%, but this was less than all funds on average and much less than the S&P 500. This result is consistent with the hypothesis that markets are efficient and the out performance in the 1970’s was due to luck and not skill.

Advertisement
Advertisement

Comments

Jul 24, 2014 8:49pm
CAP1972
Interesting article. It really speaks to the power of using index mutual funds or ETF's to simply track market returns, rather than trying to beat them. Of course, my inner Warren Buffet says,"No! Keep trying!!!" Sadly he also also says, "Unless you are me, good luck."
Aug 7, 2014 6:47pm
Joey_Batz
I was going to say the same thing. He actually recommends index funds to the average, "know nothing" investor who doesn't have the time to research individual stocks (I believe he recommends anything that tracks the S&P 500). Traditional mutual funds try to beat the market, but no professional money manager can predict where the market will go in the short term. An index fund is the perfect alternative.

Me, though, I prefer individual stocks. I think they are much safer than people think, and possibly one of the safest investments of all if you do your research and make sure that you are very well diversified.
Jul 27, 2014 12:48pm
Rolandos
great description
Add a new comment - No HTML
You must be logged in and verified to post a comment. Please log in or sign up to comment.

Explore InfoBarrel

Auto Business & Money Entertainment Environment Health History Home & Garden InfoBarrel University Lifestyle Sports Technology Travel & Places
© Copyright 2008 - 2016 by Hinzie Media Inc. Terms of Service Privacy Policy XML Sitemap

Follow IB Business & Money