We’ve all seen this on the front pages of magazine’s like Money and Kiplinger’s: “Five funds you need to buy now!”, or “The 50 Best Mutual Funds and ETF’s for 2018.” You may also be familiar with Morningstar’s star rating system where they rate a fund on a scale of 5 stars with 5 the highest. Advisors and consumers have relied on that star system for years to help them choose mutual fund managers. Does it really help? In 2017 the Wall Street Journal investigated the system and analyzed its predictive value; their result: Morningstar’s system is not particularly useful in predicting future performance. When they examined many 5-star funds they also discovered that many of the funds were small when they received a 5-star rating, with their high rating attracting many investors causing the fund to grow dramatically with ratings in future years falling. That might be evidence that many managers cannot invest the same way they did when they were small or that their performance might have been based originally on a few lucky picks.

A case in point is the Fairholme fund, Fairholme invests in US stock independent of size, and they seem to be all over the map over the years, investing in large, midcap and small cap at various times. (Full disclosure we use to use this fund). For years it outperformed its peers by a wide margin (13% per year), then suddenly it experienced a terrible year in 2011. That year the fund lost over 32% while the S&P index gained 2%. (Around the same time Morningstar named Fairholme fund of the year). Now if you compare Fairholme to the S&P 500 index, the Russell Midcap Index and Russell 2000 it has severely underperformed all of them:

Since their focus on company size has been variable we think it is fair to compare them to these three indices.
So how can you tell a manager’s performance is really based on skill? (Something you would have wanted to know about the manager of Fairholme in 2010 when they seemed to be crushing most equity indices). There are ways to analyze their performance using statistics. Comparing a manager’s performance against various indices provides useful information regarding their investment approach (this is called style analysis). You can then compare their performance against a “synthetic” fund that is composed of those indices. Using the composition of the fund and comparing it to a combination of index funds that would match that composition some have concluded that it would take at least 18-20 years to determine if Fairholme’s out performance (before 2011) was manager skill or luck. For some funds with a more volatile track record it might take as long as 100 years before it can be shown with a high degree of certainty that a fund’s performance is based on skill.

Active managers also have some headwinds when compared to an index fund: the low expense ratio and greater tax efficiency of most index funds. Most actively managed funds have expense rations in the .8-1.2% range annually while most index funds are in the .1-.35% range. Just to match an index the fund manager has to automatically outperform it by .7% or more, a high hurdle. That combined with the fact that Index funds tend to be more tax efficient means that at the beginning of every year a fund manager has to beat an index by over 1% on average just to justify their existence.

Over the years we have gradually concluded that it is easy to try to find a fund that seems to have beaten the market but it is hard to find one whose performance can be proven to be skill and not luck. Because of this we mainly use funds and ETF’s that are index based or based on a strategy that is not an attempt by a manager to “beat” the market but is instead based on a mechanistic strategy. A strategy meant to capture a certain risk vs. return component of the market or a particular exposure that fits into our client’s overall asset allocation.