A Bold Way to Pick “Winners”

It’s a mystery to me why so many investors pay brokers to pick “winning” mutual funds. But they do, and it turns out that they aren’t alone in this often fruitless quest. Pension funds pay obscene fees to “consultants” who claim the ability to select outperforming mutual funds or other types of investments.

A flawed process

The process these “experts” follow would be amusing if it didn’t cause retirement plan beneficiaries so much harm. First, they select fund managers likely to outperform, based largely on past performance. Periodically, they meet with plan sponsors to eliminate fund managers who have failed to continue to outperform. They replace them with new fund managers, again based largely on their recent track record of outperformance.

There’s only one problem. This process doesn’t work. Actually, let me clarify that. It works great for brokers and pension plan consultants. They reap commissions and fees for the dissemination of their “expertise.” It doesn’t work so well for investors and plan beneficiaries, however. They typically end up with returns that underperform risk-adjusted benchmarks, and are charged handsomely for this poor result.

A recent academic paper exposes this process for the sham that it is.

“Losers” beat “winners”

The study examined whether selecting fund managers based on recent performance was likely to lead to a favorable outcome prospectively. It looked at the performance of U.S. equity mutual funds in three-year tranches from January 1994 to December 2015. It also evaluated a number of strategies for picking outperforming mutual funds. These included a “winner” strategy (picking from top-performing funds), a “median” strategy (picking from average-performing funds) and a “loser” strategy (picking from funds not on recommended buy lists and not recommended by advisors). The authors then analyzed the performance of the very poorly performing funds (those that underperformed their benchmarks by 1 percentage point or more, as well as those that underperformed by more than 3 percentage points).

Here’s the bottom line of the findings in the study: “A heuristic of hiring recently outperforming managers and firing recently underperforming managers turns out to be 180 degrees wrong.”

The study found that hiring managers with mediocre track records led to better results than hiring past winners. And the strategy of hiring past losers had the best track record. Funds that underperformed by at least 3 percentage points (the “losers”) went on to outperform funds that had outperformed by at least 3 percentage points (the “winners”), returning 10 percent versus 8.9 percent.

The big charade

The ramifications of this study are profound. It exposes the conduct of pension plans, endowments, 401(k) plans and brokers who claim to be able to select outperforming actively managed mutual funds as a charade. The study notes that firing managers with poor recent performance and hiring those with recent positive performance is “one of the most important statistics for firing managers, and is critical in the hiring decisions as well.” It’s also consistent with the algorithm behind Morningstar’s star rating, “which gives the heaviest weight to the past three-year performance.”

The study turns this process on its head, noting, “If the results are accepted at face value, and if past performance is used at all for hiring and firing managers, it is the best-performing managers who should be replaced with those who have performed more poorly.”

Don’t ignore the data

The authors of the study note the “immense literature” finding little evidence that fund managers can consistently outperform the market on a risk-adjusted basis. The securities industry and investment consultants hope you will ignore this data. Alternatively, you could follow the results of the study to their logical conclusion and adopt a strategy of picking funds with a recent history of poor returns, but here’s a better idea:

Abandon the elusive goal of trying to “beat the market” by selecting outperforming actively managed funds. Limit your investments to a globally diversified portfolio of low-cost, passively managed funds that capture global market returns. Focus on your asset allocation (the division of your portfolio between stocks and bonds) and deferring or avoiding taxes.

As an individual investor, you can easily implement this strategy. If you are a beneficiary of a pension plan or a participant in a 401(k) plan, you have to hope your plan sponsor pays attention to this study and changes its policy for selecting the funds in your plan. If it doesn’t, maybe the threat of litigation holding them responsible for not paying attention to the “immense literature” will cause them to change their fund-selection policy.

This commentary originally appeared April 5 on HuffingtonPost.com

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

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Dan Solin

Dan Solin is a New York Times bestselling author and has published several books on investing, including his “Smartest” series. In addition, he writes financial blogs for The Huffington Post and Advisor Perspectives. Dan is a graduate of Johns Hopkins University and the University of Pennsylvania Law School.

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