Better Than a Dartboard… But Worse Than An Index

December 22, 2006

Picking mutual funds is tricky business. That’s why most individual fund investors underperform the S&P 500 index. But in theory it should be easier than choosing stocks. The expert fund managers are doing the difficult work of picking the stocks to buy and sell. Investors just have to pick the right pickers.

There are dozens of reasons a mutual fund that had been a top performer can suddenly stop performing well. Professional fund analysts exist to look beyond the mere data and do actual fund manager interviews and additional research. Morningstar, the world’s premier mutual fund research company, has a sea of analysts keeping tabs on the growing (and growing….) list of funds. The job of these analysts is to choose the cream of the fund crop.

Morningstar recently updated the performance of their fund analyst picks. At first blush, the results look quite good.

As their director of mutual fund research concluded, “I'm pleased to see that our picks delivered superior returns.” The test was relatively simple: “Basically, we compare each fund with its peer group and ask whether it outperformed its peer group during the time when it was a pick.” In other words, if a fund analyst picks Super Duper Large Cap Value Fund as a large-cap value fund pick, does it beat the returns of most of the large-cap value funds going forward?

“For the trailing five years, it's 65%.” Not bad. That is, until you compare Morningstar analysts’ performance to some alternatives.

First of all, if an ordinary investor throws darts at a list of funds in any category (say, large-cap value), and sits back for five years, statistically they have a 50% shot of outperforming the “peer group”. But it would be pretty easy to improve these odds.

In any fund category, up to 10% of the funds have almost no chance of beating the category average. Sort of like the horses at the race with no chance of winning – the 50:1 long shots.

Some funds continue to exist for no apparent reason. They have expense ratios double the category average, often because of diminished asset levels, and have usually underperformed their benchmark index 95% of the time going back for over a decade.

While there is little probability a fund that has performed well will continue to perform well, there is a large probability that a true perma-stinker fund will continue stinking until the fund company puts it out of its misery. That’s why Morningstar’s most accurately predictive rating is one star. Those funds tend to stay in the bottom half of the class.

So remove the easy-to-screen-out 10% of the population of real losers and your dartboard pick should beat the entire category 55% of the time.

Why stop there? If you just throw darts at the 10% of funds that are the lowest-fee funds in the category, you will probably have at least a 65% chance of beating the category over the next five years. Fees aren’t an end all be all, but they are a good starting point to identify future fund winners.

But is there an easier way to improve your odds?

Yes, it’s called an index fund. No, not any old S&P 500 or total market index fund (which will beat the entire population of all domestic fund categories about 70% of the time over five year stretches), but a category-specific index fund.

While there are more and more ways to index-invest as new ETFs are rolled out seemingly every day, investors generally don’t need to get any more creative than Vanguard.

Let’s look at relevant Vanguard index funds in the major “style box” classifications and see what percentage of funds in their peer group these index funds beat over the ensuing five years:

Large-cap value – Vanguard Value Index (VIVAX) beat 71%
Large-cap growth – Vanguard Growth Index (VIGRX) beat 61%
Large-cap blend – Vanguard 500 Index (VFINX) beat 62%
Small-cap value – Vanguard Small Cap Value Index (VISVX) beat 48%
Small-cap growth – Vanguard Small Cap Growth Index (VISGX) beat 89%
Small-cap blend – Vanguard Small Cap Index (NAESX) beat 50%
Mid-cap value – no Vanguard index fund five years ago
Mid-cap growth – no Vanguard index fund five years ago
Mid-cap blend – Vanguard Mid Cap Index (NAESX) beat 83%

And what about other fund categories?

Short-term bond – Vanguard Short Term Bond Index (VBISX) beat 61%
Long-term bond – Vanguard Long Term Bond Index (VBLTX) beat 39%
Intermediate-term bond – Vanguard Total Bond Index (VBMFX) beat 54%
Japan – Vanguard Pacific Stock Index (VPACX) beat 88%
Balanced (moderate allocation) – Vanguard Balanced Index (VBINX) beat 65%
ForeignLarge Blend – Vanguard Developed Markets Index (VDMIX) beat 78%
Europe Stock – Vanguard European Stock Index (VEURX) beat 41%
Diversified Emerging Markets – Vanguard Emerging Market Index (VEIEX) beat 49%

Total funds: 15
Total that beat peers: 11

In other words, if you simply picked the relevant Vanguard index fund in any category you were looking to pick a winner, you had a 73% chance of beating the fund’s peer group – a better result than the experts.

The few Vanguard funds that were not in the top half of the class only did so by a very slim margin. Note that many of the winners beat far more than 50% of the competition.

These index funds are also more tax-efficient than competitors. If you look at after-tax returns of all funds in the category, your odds of winding up in the top half of the class improves significantly.

There are also commissions to consider. Buying and selling index funds at Vanguard is free, unlike trading ETFs and ordinary funds at your broker.

And index fund investors can expect to do even better than Vanguard’s 73% peer-group-beating success rate. Why? The last five years have been particularly hard times for index funds that are market-cap-weighted – as all Vanguard and most other index funds are. We told you this was going to happen six years ago. This is because larger-cap stocks have underperformed smaller-cap stocks. Most actively managed mutual funds are not market-cap-weighted (except for the closet indexers) so they had an advantage over index funds in every category in recent years – and they still royally screwed up. The small-cap-kills-large-cap jig is up. It would not surprise us to see your chance of success using index funds climb to 80% - 90%. In our own handpicked fund portfolios and favorites lists we are using more index funds than we did a few years ago.

The implications are troubling, to say the least. If experts can’t succeed, where does that leave everybody else? Fund analysts get to interview fund managers. They can also pick from any fund they want to juice their returns – including load funds – and magically ignore the performance drag of the sales loads. And yet these pros still can’t pick actively managed funds that beat relevant index funds.

What hope is there for typical fund investors – especially the millions who use 401(k)s with their limited selections of generally higher-fee funds? Print this article and give a copy to the people in charge of picking funds for your 401(k) plan.

There are more sophisticated ways to build mutual fund portfolios, but if you want an easy way to almost guarantee the funds you pick will beat the majority of the funds in their category, just buy a category index fund. If none is available go with the cheapest alternative. Don’t feel guilty for cheating. We do it ourselves all the time.

NOTE: fund category names are from Morningstar and do not match ones used on Category ratings are from Morningstar as of 10/31/06