Thursday, September 29, 2011

Avoid Hell's Kitchen and Beat 90% of All Investors

There ought to be a new entry in Wikipedia’s definition of “mean reversion” – See Bill Miller. 

I hate to kick a guy while he is down, but the Bill Miller example is just too good an opportunity for a teaching moment.  Princeton professor Burton Malkiel is famous for his book, “A Random Walk Down WallStreet.”  One of my favorite Malkiel quotes:

“if picking stocks is a random walk down Wall Street, picking funds is an obstacle course through Hell’s Kitchen.”

There is no better example of how difficult it is to not only pick stocks, but also to pick mutual funds than the Legg Mason CapitalManagement Value Fund (Ticker: LMVTX)  managed by famed investment manager Bill Miller.  Bill Miller’s face once graced the cover of virtually every investment magazine after producing one of the greatest streaks in investment history.  Miller became famous after managing to beat the S&P 500 Index 10 years in a row with his LMVTX mutual fund.

Unfortunately, as is usually the case, terrific investment returns are typically followed by dreadful investment performance.  This phenomenon has been seen time and time again, and makes picking mutual funds at least as difficult as picking winning stocks – maybe harder.  Bill Miller’s Legg Mason Capital Management Value Fund is unfortunately the poster child for this phenomenon.  After beating the S&P 500 Index 10 years in a row, the LMVTX has failed to beat the S&P 500 Index in 4 of the last 5 years, and is on pace to lose again in 2011.  What’s worse is the margin of failure. Consider the following performance figures in percentages:

2006    2007    2008    2009    2010    2011 YTD
LMVTX             5.9       -6.7     -55.1    40.6      6.7      -7.6
S&P 500         15.8       5.5     -37.0    26.5     15.1     -1.8
Difference       -9.9     -12.2    -18.1    14.2     -8.4      -5.8

Despite its name, the Legg Mason Capital Management Value Fund competes in the Large Cap Blend Morningstar category where its 5-year and 10-year performance track record is now so poor it is ranked in the bottom 1% of all mutual funds competing in that category. Don't get me wrong, Bill Miller is a very smart guy. He has done nothing "wrong."  He's just a guy who was very lucky for 10 years and he has been very unlucky more recently.  The fact is, most mutual funds fail to beat simple broad market index funds.  In that case, Bill Miller is in good company.

If this one example of how difficult it is to identify mutual funds that will outperform broad market indexes, consider the following information I gathered while perusing the Morningstar database of mutual fund returns.  Morningstar shows 1,890 mutual funds in the Domestic Large Cap Blend category (the same category in which the fund above competes).  Of these 1,890 funds only 823 have been in existence for 10 years.  Of those 823 funds with 10-year track records, only 209 or 25% have produced a 10-year return higher than their benchmark index.  So, there you go. It’s easy to find mutual funds that have beaten their index IN THE PAST.  I just found 209 of them.  But, the Bill Miller example shows you that while it is easy to find PAST WINNERS, it is impossible to predict future performance.

If that isn’t enough, consider the Morningstar database of 426 Mid Cap Blend mutual funds. 193 of these funds have a 10-year track record, but only 25 of these beat the relevant mid cap index over the 10-year period.  That’s right, only 13% of all mid cap blend mutual funds beat their benchmark index. Another way to look at it is 87% of the mid cap blend mutual funds failed to beat their benchmark index. 

And, the data on the funds above OVERSTATE the performance of mutual fund managers due to something called survivorship bias.  The Morningstar database only shows the funds in existence right now, and does not include the hundreds of funds that went out of business over the past 10 years due to poor performance. Thus, your odds of picking a fund that will outperform index mutual funds IN THE FUTURE is likely less than 10%.  (This will be the topic of another post, soon).


The lesson here is that it is extremely tough to pick winning mutual funds since their historical track records provide no guide for the future whatsoever.  The funds with great track records rarely give a repeat performance.  So, how is an investor supposed to pick mutual funds that will beat stock market indexes IN THE FUTURE? You can’t, so just buy index funds and you will likely beat 90% of all investors. 

So, when your over-paid investment advisor shows you a list of 8-10 mutual funds with fantastic performance records that he/she recommends you buy, don’t be impressed.  Turn and walk away.  There are many good index funds out there, but I have always recommended Vanguard mutual funds to my friends, family, and in my books.

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