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Tuesday, June 12, 2012

Is Mutual Fund Prowess Luck or Skill?

Reported by Irene Park

Companies often tout the longterm tenures of their star mutual fund managers. But that may be misleading, according to a new study that calls foul on the idea that more experience equals better skill. Indeed, chief investment officers may want to take note that the research shows PMs may do their best work early on, only to fade later.

In fact, random luck may account for the success of many top mutual fund managers, according to finance professorJack Trifts of Bryant University and associate finance professorGary Porter of John Carroll University's Boler School of Business.

"If you're having heart surgery most people would prefer to have someone with experience, and not someone fresh out of the box," Trifts said. "Generally, we would expect professionals to have a better learning curve after so many years, but in fact, the results we show are exactly the opposite. But the longer [mutual fund managers] manage funds, the more likely they are to revert to becoming average."

In a comparison of performance by 289 solo managers -- all of whom had at least ten years of experience managing funds -- of 355 actively managed mutual funds, Trifts and Porter found that managers seemed to show their best performance early in their careers, generally fading after their first three years on the job. In addition, of the 25 best solo managers, 15 produced lower annual returns in the latter years of their tenure, they pointed out.

Performance was rated based on market-adjusted compound annual return (MACAR), or the average annual nominal return less the return on the market.

Greater inflows into funds and higher competition in the mutual fund industry may also account for declining performance, Trifts said. However, the fact that just about half of managers saw their results decline is "consistent with a random pattern," he stressed.

"Regardless of the level of skills, there will be individuals who have done well compared to their peers, and others who have done abysmally," Trifts said. "Over long periods of time, you have a handful of managers who have done extraordinarily well. They may have done well, or maybe there's an element of randomness in there."

The study ranked mutual fund managers based on several metrics, providing top 50 lists according to MACAR adjusted by the return on the value-weighted CRSP index, nominal compound annual return, Jensen Alpha and Carhart Alpha.

Only four managers ranked in the top 25 by all four metrics. These included legendary retired PM ofFidelity Magellan Peter Lynch, whose career MACAR of 380.46 percent is greater than any other manager;John Montgomery withBridgeway Ultra-Small Company andBridgeway Aggressive Investors I;Edward Antoian withDelaware Growth Opportunities A; andCharles Royce withRoyce Heritage Svc.

However, even Lynch showed a downward change in performance, dropping from an average 20.23 percent MACAR during the first three years of his career to 10.40 percent in subsequent years.

Trifts and Porter's findings appear in the latest issue of theJournal of Applied Finance (vol. 22, no. 1). The paper was titled "The Best Mutual Fund Managers: Testing the Impact of Experience Using a Survivorship-bias Free Dataset."


Mutual fund managers may owe their success to luck more than skill, and that luck will turn, research shows

SMITHFIELD, R.I. (June 12, 2012) — Mutual fund companies regularly imply, implicitly or explicitly, that manager tenure and experience matter but such claims aren’t borne out by research conducted by Bryant University Professor of Finance Jack W. Trifts.

In fact, he and Gary E. Porter, associate professor of finance at John Carroll University’s Boler School of Business, found that even the best solo mutual fund managers seem to get worse at their craft the longer they practice it.

“We think this occurs because ‘superior performance’ is really just random luck,” Trifts says. “Mutual fund managers who have high performance early in their careers are branded stars while those with poor performance tend to disappear from the industry.” But those stars fade: The longer a manager runs a fund, the higher the likelihood of mean reversion setting in, “even for people like Peter Lynch, argued by some to be the greatest fund manager of all time,” Trifts said. (In this video, Trifts uses the example of a flip of a coin to illustrate how successful mutual fund management is closer to random luck than it is to skill.)

To arrive at that conclusion, Trifts and Porter examined data spanning more than 80 years to identify the best solo mutual fund managers and the keys to their success. They also examined the relationship between performance and tenure in a sample of 289 solo managers of 355 actively- managed funds within the nine Morningstar styles. Their findings appear in the latest issue of Journal of Applied Finance (vol. 22, no. 1) in a paper titled “The Best Mutual Fund Managers: Testing the Impact of Experience Using a Survivorship-bias Free Dataset.”

Among the paper’s findings:
  • Solo fund managers who survived more than 10 years were likely to have performed at or above the market in their first three years;
  • Managers with tenure of 10 or more years are likely to have significantly poorer performance the longer they mange;
  • Although each of the very best managers generated positive compound annual market-adjusted returns following their first three years, the majority were not able to maintain that level of performance.

A .pdf of the paper is available from Bryant University. Contact Tracie Sweeney (tsweeney@bryant.edu) for a copy.


 Tracie Sweeney / tsweeney@bryant.edu

Bryant University, Smithfield, RI

(401) 232-6183


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