If markets do a good job of pricing securities, you should expect managers who focus on finding pricing “mistakes” to struggle. Dimensional’s US Mutual Fund Landscape 2019 study confirms this principle, showing that most fund managers underperform their benchmarks.1 The results suggest that investors are best served by relying on market prices.
The global financial markets process millions of trades worth hundreds of billions of dollars each day. These trades reflect the viewpoints of buyers and sellers who are investing their capital. Using these trades as inputs, the market functions as a powerful information-processing mechanism, aggregating vast amounts of dispersed information into prices and driving them toward fair value. Investors who attempt to outguess prices are pitting their knowledge against the collective wisdom of all market participants.
So, are investors better off relying on market prices or searching for mispriced securities?
Mutual fund industry performance offers one test of the market’s pricing power. If markets do not effectively incorporate information into securities prices, then opportunities may arise for professional managers to identify pricing “mistakes” and convert them into higher returns. In this scenario, we might expect to see many mutual funds outperforming benchmarks. But the evidence suggests otherwise.
Across thousands of funds covering a broad range of manager philosophies, objectives, and styles, a majority of the funds evaluated did not outperform benchmarks after costs. These findings suggest that investors can rely on market prices.
The size of the mutual fund landscape can obscure the fact that many funds disappear each year, often due to poor investment performance.
Investors may be surprised by how many mutual funds disappear over time. More than half of the equity and fixed income funds were no longer available after 20 years.
Including these non-surviving funds in the sample is an important part of assessing mutual fund performance because it offers a more complete view of the fund universe and possible outcomes at the time of fund selection. The evidence suggests that only a low percentage of funds in the original sample were “winners”—defined as those that both survived and outperformed benchmarks.
The sample includes funds at the beginning of the 10-, 15-, and 20-year periods ending 31 December, 2018. Survivors are funds that had returns for every month in the sample period. Winners are funds that survived and outperformed their benchmark over the period.
Survival and outperformance rates were low. For the 20-year period through 2018, 23% of equity funds and 8% of fixed income funds survived and outperformed their benchmarks.
Some investors select mutual funds based only on past returns. But sometimes good track records happen by chance, and short-term outperformance fails to repeat.
The exhibit shows that among funds ranked in the top quartile (25%) based on previous five-year returns, a minority also ranked in the top quartile of returns over the following five-year period. This lack of persistence casts further doubt on the ability of managers to consistently gain an informational advantage on the market.
Some fund managers might be better than others, but track records alone may not provide enough insight to identify management skill. Stock and bond returns contain a lot of noise, and impressive track records may result from good luck. The assumption that strong past performance will continue often proves faulty, leaving many investors disappointed.
At the end of each year, funds are sorted within their category based on their five-year total return. The tables show the percentage of funds in the top quartile (25%) of five-year performance that ranked in the top quartile of performance over the following five years. Example in upper chart (2014–2018): For equity funds ranked in the top quartile of performance in their category in the previous period (2009–2013), only 25% also ranked in the top quartile in the subsequent period (2014–2018).
Most funds in the top quartile of past five-year returns did not repeat their top-quartile ranking over the following five years. Over the periods studied, top-quartile persistence of five-year performers averaged 21% for equity funds and 28% for fixed income funds.
The performance of US-domiciled mutual funds illustrates the power of market prices. For the periods examined, the research shows that:
The results of this study suggest that investors are best served by relying on market prices. Investment methods based on a manager’s ability to outguess market prices have resulted in underperformance for the vast majority of mutual funds.
We believe the research highlights an important investment principle: The capital markets do a good job of pricing securities, which intensifies a fund’s challenge to beat its benchmark and other market participants.
Despite the evidence, many investors continue searching for winning mutual funds and look to past performance as the main criterion for evaluating a manager’s future potential.
Choosing a long-term winner involves more than seeking out funds with a successful track record, as past performance offers no guarantee of a successful investment outcome in the future. Moreover, looking at past performance is only one way to evaluate a manager.
In the end, investors should consider other aspects of a mutual fund—such as underlying market philosophy and robustness in portfolio design—which are important to delivering a good investment experience and, ultimately, helping investors achieve their goals.
1 In the study results, “benchmark” refers to the primary prospectus benchmark used to evaluate the performance of each respective mutual fund in the sample where available. See Data Appendix for additional information.
US-domiciled open-end mutual fund data is from Morningstar.
Equity fund sample includes the Morningstar historical categories: Diversified Emerging Markets, Europe Stock, Foreign Large Blend, Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Blend, Foreign Small/Mid Growth, Foreign Small/Mid Value, Global Real Estate, Japan Stock, Large Blend, Large Growth, Large Value, Mid-Cap Blend, Mid-Cap Growth, Mid-Cap Value, Miscellaneous Region, Pacific/Asia ex-Japan Stock, Real Estate, Small Blend, Small Growth, Small Value, World Large Stock, and World Small/Mid Stock.
Fixed income fund sample includes the Morningstar historical categories: Corporate Bond, High Yield Bond, Inflation-Protected Bond, Intermediate Government, Intermediate-Term Bond, Long Government, Muni California Intermediate, Muni California Long, Muni Massachusetts, Muni Minnesota, Muni National Intermediate, Muni National Long, Muni National Short, Muni New Jersey, Muni New York Intermediate, Muni New York Long, Muni Ohio, Muni Pennsylvania, Muni Single State Intermediate, Muni Single State Long, Muni Single State Short, Short Government, Short-Term Bond, Ultrashort Bond, and World Bond.
Additional information regarding Morningstar’s historical categories is available from Dimensional upon request.
Index funds and funds of funds are excluded from the sample. Net assets for funds with multiple share classes or feeder funds are a sum of the individual share class total net assets. The return, expense ratio, and turnover for funds with multiple share classes are taken as the asset-weighted average of the individual share class observations. Fund share classes are aggregated at the strategy level using Morningstar FundID.
Each fund is evaluated relative to its respective primary prospectus benchmark as of the end of the evaluation period. Surviving funds are those with return observations for every month of the sample period. Winner funds are those that survived and whose cumulative net return over the period exceeded that of their respective primary prospectus benchmark. Loser funds are funds that did not survive the period or whose cumulative net return did not exceed that of their respective primary prospectus benchmark. Where the full series of primary prospectus benchmark returns is unavailable, funds are instead evaluated relative to the Morningstar category index assigned to the fund’s category at the start of the evaluation period.
Index data provided by Bloomberg Barclays, MSCI, Russell, FTSE Fixed Income LLC, and S&P Dow Jones Indices LLC. Bloomberg Barclays data provided by Bloomberg. MSCI data © MSCI 2019, all rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. FTSE fixed income indices © 2019 FTSE Fixed Income LLC. All rights reserved. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
Indices are not available for direct investment. Their performance does not reflect the expenses associated with management of an actual portfolio.
References to “Dimensional” in this material include the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd, Dimensional Ireland Limited, Dimensional Japan Limited, and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
This material has been prepared by Dimensional Fund Advisors LP and is provided in Australia by DFA Australia Limited (AFS Licence No.238093, ABN 46 065 937 671). This material is made available for educational purposes, and it is not to be construed as a recommendation of any particular security, strategy, or investment product.
The Funds referred to in this article are U.S. mutual funds which are not registered as managed investment schemes with the Australian Securities and Investments Commission, and in providing this presentation, DFA Australia Limited is not making an offer or recommendation to Australian investors to buy or sell shares in the funds, whether directly or indirectly.