The best managers don't stay at the top

If outperformance by active managers was truly due to skill, we should see the best performers stay at the top from one period to the next. However, a report by Standard & Poor's shows that the "best" don't repeat more often than chance would suggest.

The efficient-market hypothesis asserts that financial markets are "informationally efficient." That is, investors shouldn't expect to consistently beat market returns on a risk-adjusted basis (unless they have an advantage such as insider information). However, this doesn't rule out the possibility that investors will outperform. In fact, given the large numbers of investors engaged in the effort, we should expect to see many randomly outperform their appropriate risk-adjusted benchmarks purely by chance. However, we should expect that as the investment horizon increases, the percentage that outperforms will decrease.

Standard & Poors' Persistence Scorecard provides us with data that allows us to see if there's persistence of outperformance beyond the randomly expected. Here's what it found: Just 12.2 percent of large-cap funds ranked in the top 25 percent of returns over the five years ending September 2006 maintained their status over the next five year period. Randomly we would expect 25 percent to do so. S&P also found that only 3.1 percent of mid-cap funds and 20.2 percent of small-cap funds maintained a top-quartile performance over the same period.

It also found that while top-quartile and top-half repeat rates have been at or below the levels one expects based on pure chance, there's consistency in the death rate of bottom-quartile funds. Across all market cap categories, fourth-quartile funds have a much higher rate of being merged and liquidated. This is an outcome we should expect. The reason is that decile rankings are highly correlated with expenses -- the higher the expense ratio, the worse the performance tends to be. Thus, funds with higher expenses are the most likely to be sent to the mutual fund graveyard.

S&P's findings add to the long body of evidence on the lack of persistence of performance. For example, Brad Cornell's 2009 study, "Luck, Skill and Investment Performance," analyzed 1,034 large-cap value funds. Cornell found that the great majority (92 percent) of the cross-sectional variation in fund performance is due to random noise. This result demonstrates that "most of the annual variation in performance is due to luck, not skill." He concluded: "The analysis also provides further support for the view that annual rankings of fund performance provide almost no information regarding management skill."

Professors Eugene Fama and Kenneth French also studied this issue in their March 2009 paper "Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates." They found that active managers as a group haven't added any value over appropriate passive benchmarks. They concluded: "For (active) fund investors the simulation results are disheartening."

They did concede that the results looked better when looking at gross returns -- the returns without the expense ratio included. However, gross returns are irrelevant to investors unless they can find an active manager willing to work for free. The bottom line is that Fama and French found no evidence of fund managers with skill sufficient to cover costs.