Critique of Malkiel on Mutual Fund Performance Consistency

Monday, July 27, 2009

Burton G. Malkiel has sold over one million copies of his well-known book, A Random Walk Down Wall Street - The Time-Tested Strategy for Successful Investing. Malkiel offers great advice new entrants into the stock market helping to demystify many financial concepts. Malkiel generally argues that asset allocation is the most important part of investment return and investors should avoid individual stock-picking and mutual funds. Yet, he unfairly criticizes mutual fund manager performance in the following excerpt taken from his book:
Every year one can read the performance rankings of mutual funds. These always show many funds beating the averages-some by significant amounts. The problem is that there is no consistency to performance. Just as past earnings growth cannot predict future earnings, neither can past fund performance predict future results. Fund managements are subjects to random events: they may grow fat, become lazy, or break up. An investment approach that works very well for one period can easily turn sour the next. One is tempted to conclude that a very important factor in determining performance ranking is our old friend Lady Luck...

...The following table presents the 1980 to 1990 performance for the twenty top funds of the 1970-80 period. Again, there is no consistency. Many of the top funds of the 1970s ranked close to the bottom during the 1980s. Although the top twenty funds almost doubled average fund return during the 1970s (19.0 percent versus 10.4 percent), those same funds did worse than average (11.1 percent versus 11.7 percent) over the next decade. There was, however, one striking exception. The Magellan Fund, managed by Peter Lynch, was a superior performer in both the 1970s and 1980s. But Lynch retired in 1990 at the ripe old age of forty-six, and we will never know if he would have continued to beat the Street.

How the Top 20 Equity Funds of the 1970s Performed during the 1980s

Average Annual Return
Top 20 funds of the 1970s19.0%11.1%
Average of all equity funds10.4%11.7%

In case you think the picture changed during the decade of the 1990s, the next table shows the top twenty mutual-fund performers of the decade of the 1980s and the deterioration of their performance in the 1990s. The results are distressingly similar. Note that while the new top twenty of the 1980s were racking up 18 percent yearly gains, the top twenty from the 1970s recorded returns of only 11.1 percent. Financial magazines and newspapers will keep singing the praises of particular mutual-fund managers who have recently produced above-average returns. As long as there are averages, some manager will outperform. But good performance in one period does not predict good performance in the next.

How the Top 20 Equity Funds of the 1980s Performed during the 1990s

Average Annual Return
Top 20 funds of the 1980s18.0%13.7%
S&P 500-Stock Index14.1%14.9%
While many would find it silly to defend mutual fund managers with their typical 80% underperformance, this is not entirely our purpose. Malkiel is arguing that star portfolio managers typically cannot and will not repeat their past performances. As any seasoned investor knows, past performance is not indicative of future results. And, insofar as Malkiel is attempting to sway investors not to chase mutual fund returns, we certainly agree. Too many investors switch in and out of mutual funds chasing the latest hot manager. Any serious financial advisor can inform one of the perils of this strategy.

Yet, Malkiel's general argument that managers cannot repeat their performance sorely misses a crucial point. An efficient market hypothesis and the random walk theory would imply that manager outperformance in one period will just as likely result in a underperformance in the next period. Many traders and investors can outperform in one period by luck or by taking excessive risk. But, they will subsequently give those profits back in the next period as their luck runs out or the risk comes back to hurt them. Most investors will see their positive alpha one year quickly turn into a negative alpha the next year. Malkiel is defeating his own point by showing that the managers beat, and then held their gains.

The tables in the book show that managers can outperform. Outperformance comes from a manager beating the market during a given period and managing to keep those gains through future periods. No manager needs to beat the market every year. It is an extremely rare manager that can consistently beat the market year over year over year. Most usually, a manager will have a great idea, deviate from market weightings, possibly beat the market and then go back to matching the market. A manager who continually tries to execute less than his best ideas is likely to give back his gains.

The two charts below show how a manger beating in one period and nearly matching the market in the next period still handily beat the market returns. The charts show the return of a hypothetical $10,000 investment based on the above tables.
Malkiel is correct that investors should not chase returns of the latest hot funds featured on all the financial magazine covers every year. And he may, in fact, be correct that the likelihood of finding the managers that will outperform is so difficult that it may not be worth trying. But, his implication throughout the book is that no one will beat the market. This is clearly incorrect and investors finding an astute, trustworthy manager with a quality methodology can beat the market over the long run. This is done not by beating the market every single year, but rather beating the market and managing to keep those gains in subsequent periods.


Post a Comment