How to Choose a Mutual Fund

Clocks in store window

Here’s the scenario. You want to invest some money in the stock market but you don’t want to manage it yourself. You’re attracted to index funds and index-based ETFs because, being a good Rebel, you know that equities tends to rise handsomely in value over the long run. But you’d like a little more. How do you choose a mutual fund?

You’d like to find a fund where the manager has beaten the market average by at least a few percentage points year after year. You’ve also heard some discouraging data about the performance of active fund managers when it comes to meeting even broad markets averages. But surely somebody must be doing it right. Try as you may, you just can’t shake off the belief that professionals in the industry must be able to regularly beat the market. Peter Lynch did. Let’s find another Peter Lynch.

Tracking the track records

If you are like many investors looking for a good mutual fund, you’ll go the fund reviews and examine the top few hundred offerings. Every fund prints in large cap type in their prospectus, “PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS”. But what do you do? You look at past performance. The financial papers display past performance. The funds show large, pretty charts of past performance. What else is there to go on? A financial paper that reported future performance would sell very well.

You figure that four years is the smallest reasonable time horizon to stay invested in the stock market. You, therefore, look for funds with a minimum of four years of reported results. Though there appears to be many funds with great returns over one or two years, four years is your line in the sand. You settle on a particular actively managed mutual fund with a solid track record. If this fund has done so well for the last four years running, it should do well for the next few years as well, right?

Right?

Monkey business

Let’s play a fun thought experiment. We begin by collecting up the annual returns of 10,000 actively managed mutual funds. Let’s say that during the year, many of the funds lost money, many were about break even, and ten percent did really well.

As much as we’d like to congratulate the fund managers in the winning group, we can’t. Why? Because in our thought experiment, we replaced the investment professionals with monkeys who throw darts at stock pages in the newspaper. This is how they make their selections. Ten percent of these “managers” achieved great results, but we just don’t have it in us to congratulate monkeys.

From the original group of 10,000 funds, we track the progress of the 1,000 that did well for another year. We find once again, that ten percent of the monkey managers achieved solid results, so we track those 100 funds for another year. At the end of our thought experiment, there is one particular dart-selected fund that‘s beaten the market and achieved outstanding results four years in a row, purely by random chance.

Can you tell the difference?

Now it’s time to take he Coke and Pepsi challenge. But this time, instead of sampling colas in a blind taste test, you’ll be looking at the four-year track record of two successful, actively managed mutual funds. One box contains a professionally managed fund and is labelled only by its four-year results. The other identical box holds our monkey fund and is labelled only by its four-year results.

Can you tell the difference between the two?

Are you confident that the professionally managed fund did well due to superior investment insights? Are the monkeys underpaid?

 

Jon Dearden

 

No monkeys were harmed in the production of this article.

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