ultimate guide on choosing mutual funds

Ultimate Guide: Choosing Alpha Mutual Funds

Some investors are cool with just taking the market returns.  Others want Alpha!  Mutual funds offer a shot at market out performance but the reality is that about 60% of mutual funds don’t beat the index over a 15 year period (other research shows the number is even worse).  Still, the chance to get a better return, than market beta, is appealing.

Many investors begin their search for an actively managed fund by simply looking at the past 5 or 10 year returns, with the though that if “if it has done well in the past, it must be good”.  Caught up in the glow of a fund with a high 10 year return, and low volatility, investors skim right over and discredit that little warning in the fine print “past performance does not guarantee future results”.  Mutual fund companies know investors do this and take marketing action and jack up fees because when their returns look good they can corral in $$$.  Behind all the fluff however, is what many investors will never realize; that warning “past performance does not guarantee future results” is true.  Surprisingly, mutual funds that have outperformed are likely to under perform in the future.  The S&P Scorecard on Mutual Fund Persistence shows that of Large Cap Mutual funds that had 5 year performance in the top quartile (top 25%), only 21.15% would remain in the top quartile of performance for the subsequent 5 years (Full Report & Data here).  The trend is persistent (worse) across all equity asset classes.  In otherwords, what has done in the well past, is NOT likely to do well in the future.  Yet time and time again investors pick up an investment brochure, and want to invest in what has done well in the past.  Hell, I’m guilty of doing this myself early on in my investing life.

Past performance of mutual fund does not indicate that it will do well going forward.

If past returns aren’t likely to indicate that a mutual fund will deliver alpha, what is?

Great question.

Low Fee’s: Cheaper Funds Win

The first would be low fees.  Morningstar’s Russ Kinnel has looked at the data and found evidence concluding that mutual funds in the lowest quintile (cheapest 20%) of their respective category (large cap, small cap, balanced, intl, etc) were more likely to deliver success relative to their benchmark.  His first study in 2008 found that 48% of domestic equity funds in the cheapest quintile survived and outperformed their benchmark versus 24% in the priciest quintile.  In other words, the cheapest quintile of domestic equity was twice as likely to survive and outperform as the most expensive quintile.  Similar results were found across all other asset classes.

Kinnel researched the expense and success correlation again in May of this year, 2016,  with the same conclusion.   Over the 5 year period from 2010-2015, 62% of domestic equity funds in the cheapest quintile survived and succeeded (beat their benchmark), vs just 20% in the most expensive quintile.  The trend of success declines steadily from the cheapest quintile to the most expensive and persists across all asset classes.  All in all, the cheapest quintile is showing to be about 3x times more likely to succeed.

Cheapest mutual funds are likely to out perform their benchmarks

Maybe high fee mutual funds are ran by greedy folks, or low fees represent an internal efficiency as the result of an ability to stick to a common factor strategy?  Whatever it is, the data is consistent, in mutual funds you don’t get what you pay for!

Manager Investment Above $1,000,000

Think about this, would you eat food made by a chef who won’t eat his own cooking? If the chef who cooked it won’t eat it, there’s probably a reason why.  Of course there might be some who answered maybe so lets rephrase, wouldn’t you rather eat with the chef?

The same should apply for investing.  Shouldn’t your manager, who is in charge of your money, eat some of their own cooking?  If you’re paying them for their advice, don’t you want some confidence that their advice is good enough for them?  I think any rational person would say yes.  It would be nice to know that they are in your shoes, and are actively looking for a way to improve.

Prior to 2005, fund manager investment in their own fund was a black hole.  In 2005 however, the SEC started requiring fund managers to disclose their holdings.  An exact dollar amount specification was not required, but rather fund managers had to disclose in the following ranges; 0, $1–$10,000, $10,001–$50,000, $50,001–$100,000, $100,001–$500,000, $500,001–$1 million and over $1 million.  Back in 2005, 47% of US stock funds reported no management ownership.  71% of balanced funds had no ownership either.  There’s a few logical excuses for this, but, again research has concluded that you’re more likely to outperform if you invest with a manager who eats their own cooking.

Research again by Kinnel of Morningstar in 2015 has a shown solid evidence of this.  Among domestic equity funds with manager investment of more than $1,000,000, 39.08% succeeded in beating their benchmark compared to only 28.99% of funds with $0 invested.  The trend continues through other asset classes with Intl Equity having a success rate for funds with manager investment of more than $1,000,000, of 67.86% compared to funds with no manager investment having a success rate of less than half that at 31.65%.  Clearly when a manager’s own money is on the line, they seem to get returns.

The key takeaways here are simple:

Invest in funds with expenses in the lowest quintile.

-Only invest in funds with managers who put more than $1,000,000 of their own money where their mouth is.

How do you identify these funds with manager investment of at east $1,000,000 and/or low expenses?

Simple, Morningstar has a nifty spy selector tool, that allows you to see what each fund is sporting.  Below we see the Vanguard Wellington fund (VWELX), which is an excellent fund, sporting both an expense ratio in the lowest quintile and manager investment above $1,000,000

 

how to pick a good mutual fund

 

You might be thinking, what if we combine the 2… How likely are we to succeed if we only invest in cheap mutual funds with high manager investment?  I’m thinking the same thing, and it doesn’t seem that there is any research on it.

I generally suggest going with a ‘no fee’ mutual fund at your brokerage as opposed to paying an often $50+ commission every time you invest.  In these cases, mutual funds that meet both the low fee and high investment criteria might not be an option.  There’s no clear data on whether a low fee or high manager investment is more likely to deliver a premium, so use your own discretion.  Personally, I’d rather know that a manager is riding it out with me so I would start by find funds with manager investment over $1,000,000, offered commission free, and then pick the one with the lowest fees.
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