Analyzing Winning Mutual Funds

Long-term (and hopefully even short-term) readers know that I am a big fan of index mutual funds. I love the low costs, broad diversification, low turnover, lack of manager risk, and fidelity to their investing strategy. Most importantly, I love that they generally perform better than actively managed mutual funds in the long run. However, I have never said that they will outperform ALL actively managed mutual funds going forward. There will always be at least a few winners. I had a reader post a comment recently that put this subject back to the front of my mind. The reader's conclusion from researching and posting a group of actively managed mutual funds that had outperformed the market was entirely wrong due to a few fundamental errors, but it was fun to see who the winners were.

Using Morningstar data, the reader had basically gone back to the year he graduated from high school, 1982, and looked at all the best performing stock mutual funds. The best one from 1982 to 2020 was the Fidelity Select Health Care Fund. His conclusion? That one should invest in health care stock stocks going forward. His errors were immediately obvious to anyone who has spent any significant amount of time in a book written by Jack Bogle.

1. Only one health care fund outperformed the market. The second best health care fund over that time period underperformed an S&P 500 Index Fund.
2. The list only included the winners. There were just 129 funds on the list. The data is severely affected by survivorship bias. Outperforming mutual funds generally don't close. How many mutual funds were there in 1982? Jack Bogle's Common Sense on Investing says there were 331. By 1991, 1 in 6 had gone. After 38 years, 3 out of 5 were gone. We're only looking at the top 39% of the funds that existed in 1982.
3. There is no guarantee that past performance will persist. In fact, the data shows it is pretty unlikely.
4. Performance data like this is severely influenced by the returns at the end of the time period.

However, I still found this reader's research very interesting. I just found it interesting for an entirely different reason! His list of the 129 survivors from 1982 showed that just 26 of them had outperformed the Vanguard 500 Index Fund (started in 1976). So of the 331 funds that existed in 1982 only 26, just 8%, outperformed the market. Which funds were they? Let's take a look. This shows what a $10,000 investment on July 1, 1982, would have grown to by the end of April 2020.

There are a few things worth noting about this list.

Remember this was a list of 129 funds. I'm just showing the top 27. So the 500 Index Fund isn't at the bottom of the list, it's actually near the top of the list.

1. Of the 26 funds that outperformed the 500 Index Fund over this 38 year period, only 8 outperformed the index fund by more than 1% per year. 8 out of 331 is just 2.4%. Lots of manager risk, very little outperformance.
2. Most of these funds have much higher turnover and thus lower tax efficiency than an index fund. So in a taxable account, the after-tax return for these funds is even worse. Just by way of comparison, let's take a look at the Columbia Acorn Fund. Morningstar reports a current turnover ratio of 101%. So on average, every stock in the fund is bought and sold every year. The 500 Index Fund has a turnover of 4%, meaning the stocks are sold on average every 25 years. You can imagine the comparative tax-efficiency and resulting tax drag on the Acorn fund returns.
3. Many of these funds charge a load. That load is not taken into account in these returns. Granted, even an 8% load is not very large when averaged over 38 years, but it's not zero.
4. I mentioned above that performance data of this type is severely influenced by the returns at the end of the time period. Over the last 5-10 years, Growth Stocks and Large Stocks have outperformed the overall market, despite the fact that over the long run Value Stocks and Small Stocks have outperformed the market. So it should be no surprise to see that most of these 26 winners were composed of Large Growth stocks. Remember that most tech stocks and health care stocks are also large or mid cap growth stocks. Of the 26 winners, 15 of them were Large Growth or Mid Cap Growth stock funds. Of the large blend funds (the ones most appropriate to compare to the 500 Index Fund), there were only 5 that outperformed the index, none by more than 1% per year. If you should be impressed with anything, it is the single Large Value fund on the list (Dodge & Cox), the single Small Blend fund on the list (Royco Pennsylvania), the single Utilities fund on the list (PGIM Jennison), and the two World funds on the list (American Funds New Perspective and Invesco Oppenheimer Global).

I think it is pretty clear that despite the fact that there turned out to be 26 winners here, that the correct a priori decision in 1982 would have been to simply invest in an index fund, but draw your own conclusions from this data.

10 Year Mutual Fund Data with Fidelity and Vanguard

As I pondered the above data, I thought it might be fun to look at some mutual fund screeners to see what could be gleaned from more recent data. Both Fidelity and Vanguard have mutual fund screeners on their websites, so on May 2nd, 2020, I went ahead and pulled up the list of Large Blend Funds. Now the performance data on both of these sites only goes back 10 years. But I ranked all of the funds by return over that ten year period.

Fidelity

The Fidelity site pulled up 526 Large Blend funds that have been in existence for the last 10 years. (Remember this data is skewed by survivorship bias as any fund that went out of business in the last ten years is not included in the data.) I ranked them top to bottom. There were 27 pages of funds on the list. The first 500 index fund was found at the bottom of the first page. Most of the second page was composed of index funds.

Which funds outperformed the 500 index fund? Well, there were 19 of them. 19 out of 526. Just 3.6%. After only 10 years the market had outperformed over 96% of the active managers, before taxes and ignoring survivorship bias. So which were the funds? Well, to make matters worse, many of them were simply various share classes of the same fund. There were really only 11 outperformers. Here they are (listing the best performing share class):

Yes, the Fidelity 500 fund outperformed the Vanguard fund over this time period by 0.02%. So I stopped the list there. Vanguard's list should look pretty similar.

Vanguard

Vanguard found 364 funds but would only let me display 250 of them, so I had to only look at the funds with a positive return over the last 10 years (there were apparently 114 large blend funds that did not have a positive return over the last decade.) Vanguard, like Fidelity, also apparently leaves some funds out. Vanguard's list had no Fidelity funds just as Fidelity's list left off many of the Vanguard index funds. Competitive business this. At any rate, here's the list of the winners over the last 10 years at Vanguard.

The lists are slightly different, presumably due to different methodologies such as using different share classes, including any load, and exact days. Plus some bias in excluding their main competitor's funds! But the fact is the lists pretty much agree with each other. There are eight winners that show up on both lists.

But you know what is really interesting? Not one of those 8 funds showed up in my reader's research. None of the 5 large blend funds that beat an index fund over the 38 year period also did so over the last 10 years. Even if I include the growth stock funds in the analysis, only a few of the winners made my readers 38-year list and my 10-year list. Here they are:

Of the 15 growth stock funds from my reader's initial 38-year outperformer list, only 7 beat the 500 index fund over the last 10 years, and only 3 of those beat a growth stock index fund, 1 by more than 1% per year. That fund was a tech fund, and it underperformed its equivalent index fund, the iShares US Technology ETF, over the last 10 years by over 1%. And remember that the 38 year period INCLUDES the 10 year period and in fact weights it heavily. If I looked at two completely separate time periods, there may be no overlap at all.

Repeat after me:

• Past performance does not indicate future results.
• Past performance does not indicate future results.
• Past performance does not indicate future results.
• Past performance does not indicate future results.
• Past performance does not indicate future results.
• Past performance does not indicate future results.
• Past performance does not indicate future results.
• Past performance does not indicate future results.
• Past performance does not indicate future results.

Repeat it until you believe it. Because it is true. And that's before correcting for survivorship bias. And before correcting for taxes. And before correcting for the cost of paying an advisor to pick you some winning mutual funds.

Dave Ramsey is fond of saying that it is easy to find “good growth stock mutual funds that will beat the S&P 500” and “get a 12% return.” And that you can easily get help doing that by hiring one of his endorsed mutual fund salesmen. That assertion does not stand up to the data. He readily acknowledges he is not a stock market expert and came into the financial space from the real estate side. But that's no excuse for ignoring data like this. And all long-term data looks like this.

The Stock (or Fund) Picker's Dilemma

So now, dear reader, if your stock portfolio is not composed entirely of low-cost index funds, you are faced with a dilemma.

If you are using actively managed mutual funds, why do you think you are going to be able to pick a winner, much less a winner in every asset class in your portfolio? Why would you gamble on such low-probability bets?

If you are trying to pick stocks yourself, why do you think you're going to be able to outperform the market when essentially not one of these folks was able to do so over the long run in any significant way? If you truly can pick stocks well enough to beat the market after the costs of doing so, why are you only managing your own money? Not only are you leaving billions on the table, but you're doing a disservice to your fellow investors.

If you will honestly track your returns, especially your after-tax, after-expense, after-the-value-of-your-time returns, you will soon become a committed index fund investor. There is no other reasonable approach. The data is overwhelming. If you want to invest money in some way where your effort and expertise have any chance of adding value to the equation, find an asset class besides the publicly traded equity markets to do it in. Perhaps small businesses, websites, or real estate.

What do you think? Are you surprised the list of winners is so small and so unlikely to repeat? If you are using actively managed mutual funds or picking your own stocks, why do you persist in doing so in the face of data such as this? How is that a good use of your time? Comment below!