Can you find a needle here?

When it comes to mutual fund investing, the focus of most investors is to find outperforming fund managers. Many financial advisors justify their hefty fees by claiming they can do just that.

Finding a skilled manager is actually a daunting challenge, because it is hard to separate skill from luck. Take Bill Miller, the legendary manager of Legg Mason Value Trust, for example. He outperformed the S&P 500 index for 15 consecutive years. Iron-clad proof he has the skills, right?

Then, in 2006, 2007, 2008, he underperformed the S&P 500 by 10.4%, 12%, and 18%, respectively. His performance was so dismal that the fund’s average annual return since its inception was 11.1% versus 10.9% for the S&P 500. What’s more, on dollar weighted returns, he underperformed the S&P 500 by a huge margin, since most investors joined the fund in 2003, 2004, and 2005, just before it headed for the cliff. So was he skilled and fell asleep during the bad years? Or was he just very lucky, then very unlucky?

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Recently, three finance professors¹ came up with a methodology to separate skilled managers from lucky ones. Then, they used their methodology to examine the performance of 2,076 mutual funds between 1975 and 2006. Their paper was published in the prestigious Journal of Finance. Here is what they discovered:

Our decomposition of the (mutual fund) population reveals that 75.4% are zero-alpha funds – funds that have managers with some stock-picking ability, but that extract all of the rents generated by these abilities through fees. Further, 24.0% of the funds are unskilled, while only 0.6% are skilled – the latter being statistically indistinguishable from zero.

Putting this in layman’s terms, 75.4% of fund managers have a little skill, but whatever extra money they make, they take it for themselves through fees. A full 24% of fund managers have no skill whatsoever; they basically charge you fees to lose your money. Only 0.6% of fund managers are worth their salt. To investors and financial advisors who think they can find winning fund managers, I say, “Good luck finding a needle in a haystack.”

As for me and my clients, Vanguard and DFA’s passive investing funds work just fine.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

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1. Professor Barras is at the Desautels Faculty of Management at McGill University, Professor Scaillet is at the Swiss Finance Institute at HEC-University of Geneva, and Professor Wermers is at the Robert H. SmithSchool of Business at the University of Maryland at College Park