In the search for active managers who will deliver alpha—what I call the Holy Grail of outperformance—investors, both individual and institutional, will almost always examine a mutual fund’s prior performance record. Doing so is a logical starting point for evaluating any new investment and, a necessary step in the due diligence process. Clearly, no one would purposely choose to invest with a fund or manager that demonstrated a record of underperformance.
However, because even believers in active management must recognize that positive past performance could simply be reflective of a random outcome, additional screens are generally established. Among the most common is management tenure. The assumption is that a fund manager’s long tenure, combined with superior performance, is an indicator of skill.
If the length of a fund manager’s tenure is related to their ability to provide superior performance, then it should be a factor in explaining the size and persistence of fund returns. Unfortunately, as is true with much of the “conventional wisdom” about the mutual fund industry, the data simply doesn’t support the belief.
Management Vs. Performance
Gary E. Porter and Jack W. Trifts—authors of the study “The Career Paths of Mutual Fund Managers: The Role of Merit,” which appeared in the July and August 2014 issue of Financial Analysts Journal—sought to answer the following question: While it’s logical to expect that managers with greater skill will outperform those with less skill and enjoy longer careers, do longer tenure managers actually outperform and deliver alpha?
They began by focusing on the careers of mutual fund managers who are in sole control of their funds. To avoid the problem of survivorship bias, their study covers the period from 1996 through 2008. The data set incorporated 2,846 funds and 1,825 managers, and included 195 funds with managers that had at least 10 years of experience (6.9 percent of the total). Their research resulted in three key findings:
As we would expect, turnover is, at least in part, related to performance. Poor performance does lead to firing.
In any given year, even the longest-surviving solo managers are unlikely to produce significantly more positive style-adjusted monthly returns than negative ones.
While longer-tenure managers outperform their peers, they show no ability to deliver alpha, or outperformance relative to their risk-adjusted benchmarks.
The authors concluded: “The key to a long career in the mutual fund industry seems to be related more to avoiding underperformance than to achieving superior performance.”
These findings add weight to those of a 2003 study, “Mutual Fund Managers: Does Longevity Imply Expertise?” The study covered 1,042 funds operating during the period from 1986 through 1995. This period produced a variety of market conditions, including the crash of 1987, a recession and bear market in 1991, followed by a bull market that extended through 1995. The test sample contained 112 funds whose management had 10 or more years of tenure. The authors found that regardless of tenure, managers producing positive risk-adjusted returns for three years aren’t likely to repeat their performance in subsequent periods. They concluded: “We find no compelling reason to believe that manager tenure is a proxy for expertise that produces superior or consistent performance. Our results provide further evidence that tenure shouldn’t be a factor in selecting mutual funds. The results reveal that, even among the top performers, funds managed by individuals with at least 10 years tenure offer no greater excess returns.”
The Bottom Line
Despite the published research, it seems likely that the public will continue to consider management tenure as part of its screening process. Myths do die hard. And hope does, after all, spring eternal. Wisdom, however, is the triumph of experience over mere hope.
The bottom line is that this study provides further evidence against active management as the winning strategy. Rather, the winning strategy is to use passively managed funds to implement your financial plan. Passively managed funds, as a category, include not just index funds, but also funds whose construction rules are transparent, systematic and based on historical evidence.
Larry Swedroe is director of research for The BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.
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