Do Mutual Fund Managers Make Better Personal Investment Decisions?

There’s an overwhelming body of evidence demonstrating that individuals would be best served by investing in index funds, or other similar passively managed financial vehicles. Their failure to do so can be blamed both on the lack of financial sophistication—unless you have an MBA in finance, it’s unlikely you’ve taken even a single course in capital markets theory—and behavioral biases that lead to investment mistakes.

In fact, the evidence clearly shows that individuals exhibit perverse stock picking skills. The stocks they buy tend to underperform going forward and the stocks they sell tend to outperform going forward.

An interesting question is whether the assumed financial sophistication of mutual fund managers allows them to make better personal investment decisions than the typical individual investor. To find an answer, Andriy Bodnaruk and Andrei Simonov, authors of the 2014 paper (Do Financial Experts Make Better Investment Decisions?) compared the private investment decisions made by these financial experts to those of individual investors similar in a number of socio-economic characteristics, but presumably lacking in financial expertise. Their study covered the six-year period from July 2001 through June of 2007.

Bodnaruk and Simonov examined the personal portfolios of 84 mutual fund managers in Sweden (almost 40 percent of the all the mutual fund managers in that country) as well as the portfolios of their mutual funds and peer individual investors. The advantage of using Sweden for the study is that individual-level information on tax returns is publicly available from the Swedish Tax Authority offices. Thus, the authors had information on an individual’s real estate, total wealth and personal characteristics. The following is a summary of their findings:

• Financial experts don’t exhibit superior security-picking ability in their own portfolios.
• The private investments of fund managers perform on par with the investments of investors similar to them in terms of age, sex, education level, income and wealth.
• The investments of mutual funds managers underperform the private investments of the wealthiest 1 percent of investors, while doing as well as investors in 95th to 99th percentile of wealth.
• Financial experts aren’t better than their peers at diversifying risks, exhibiting similar levels of portfolio concentration.
• Neither managers nor their peers are able to beat the market. There was no evidence that they possess either stock-picking or market timing skills.
• The Sharpe ratios of mutual fund managers’ investments are similar to those of the study’s control investors, but are statistically and economically much lower than those of wealthy investors.
• There was no evidence that fund managers are less affected by behavioral biases.
• Fund managers turn over their portfolios as often as the study’s control group of investors.

The authors did uncover another interesting finding. They hypothesized that mutual fund managers, through the course of their investment work, are likely to have superior access to information and/or analysis about certain companies. Thus, to control for information differences, they split the portfolios held by managers into positions that are also held by the manager’s mutual fund (MF-related) and those which are not (non-MF-related). The authors investigated these positions separately.

They found that the non-MF-related investments of fund managers significantly underperformed their MF-related investments. This result suggests that a part of overall managerial performance should be credited to access to a mutual fund’s resources.

The findings from this study demonstrate that even a group of individual investors who have an extensive knowledge of finance gained through prior training and day-to-day experience with financial markets have a difficult time outperforming the market.

The evidence also indicate that neither mutual fund managers’ comprehensive knowledge of financial markets, nor their prolonged experience, is sufficient to provide them with enough of an advantage to enable them to generate alpha.

The bottom line is that the collective wisdom of the market is a very tough competitor indeed. If you are still engaged in active management strategies, the question you should ask yourself is: If professional money managers are unable to outperform, what advantage or skill do I have over them that will allow me to outperform? If the answer is none, as it almost certainly is, then the logical conclusion is that you should abandon the quest for alpha.