The bumpy road to outperformance

Studies have shown that, on average, actively managed mutual funds underperform their respective benchmarks. Even so, the allure of active management remains, and many investors spend considerable time and effort trying to identify potential winning managers.

Research carried out in July 2013 by Vanguard entitled The bumpy road to outperformance suggests that for those investors seeking alpha, the road to outperformance may not only be difficult to find, but it’s also likely to be uncomfortable along the way.

Long-term outperformance is rare

The first hurdle for any fund is simple survival. Vanguard found that of the 1,540 actively managed US domestic equity funds available to investors at the beginning of 1998, only 55 percent still existed by the end of 2012. The rest had either merged or been liquidated.

Of the funds that did survive, only 275 (18 percent of the initial 1,540) outperformed their respective style benchmarks over the entire 15-year period. These results confirm prior research showing that long-term outperformance is rare. But what about the 18 percent of funds that did outperform? Some investors assume that if they can select an outperforming manager, they are all but ensured a smooth stream of excess returns. To test that assumption, Vanguard closely examined the yearly returns of the funds that survived and outperformed over the 15 years from 1998 to 2012.

A bumpy road, even for the winners

Almost all (97 percent) of the outperforming funds experienced at least five separate calendar years in which they lagged their style benchmarks. More than 60 percent had seven or more years of underperformance. The results are depicted in Figure 1, which shows the distribution of outperforming funds according to their number of years of underperformance.

Even successful funds experienced multiple periods of underperformance. Successful funds are those that survived for the 15 years and also outperformed their style benchmarks. The funds’ returns were measured against benchmarks deemed to fairly represent the characteristics of the relevant market, according to Vanguard calculations using data from Morningstar.

Vanguard also looked at consecutive years of underperformance. For many investors, three consecutive years of underperformance represent a break point after which they will divest the fund. The analysis found that about two-thirds of the outperforming funds experienced at least three consecutive years of underperformance. Put differently, of the original group of 1,540 funds, only 94 (6 percent) survived, outperformed, and avoided three consecutive years of underperformance.

To shed additional light on the nature of the winning group’s excess returns, Vanguard examined the relative performance of 10 funds with annualised excess returns that matched the median for the entire group (1.1 percent annually over 15 years). Figure 2 shows calendar-year returns of those 10 funds, relative to their style benchmarks.

The 10 funds had annualised excess returns closely matching the median for all 275 successful funds: 1.1 percentage points above the relevant benchmark, according to Vanguard calculations using data from Morningstar.

It’s clear that the ride was bumpy for investors in these funds. The random pattern of excess returns among the 10 funds also highlights the challenge of ‘timing’ managers, a strategy in which investors readily move from one fund manager to another in an attempt to improve performance.

Patience can boost the odds of success

Vanguard’s research suggests that investors should be careful about using short-term performance as the primary criterion for divesting (or investing) in an active mutual fund. Short-term underperformance will likely accompany an active fund that achieves long-term outperformance. As a result, it is important to understand that to increase the odds of long-term success, alpha-seeking investors must be patient enough to endure numerous and potentially extended periods of underperformance.

Mike DeFlavia is sales executive at Vanguard. He can be contacted at:  michael_deflavia@vanguard.com

Notes: The median outperforming funds are the 10 funds which produced in annualized excess return of 1.1% over the time period studied. Data and analysis cover US active equity fund performance versus their appropriate style box benchmark. Active equity style benchmarks represented by the following indexes: Large blend—Standard & Poor’s 500 Index, 1/1997 through 11/2002, and MSCI US Prime Market 750 Index thereafter; Large value—S&P 500 Value Index, 1/1997 through 11/2002, and MSCI US Prime Market 750 Value Index thereafter; Large growth—S&P 500 Growth Index, 1/1997 through 11/2002, and MSCI US Prime Market 750 Growth Index thereafter; Medium blend—S&P MidCap 400 Index, 1/1997 through 11/2002, and MSCI US Mid Cap 450 Index thereafter; Medium value—S&P MidCap 400 Value Index, 1/1997 through 11/2002, and MSCI US Mid Cap 450 Value Index thereafter; Medium growth—S&P MidCap 400 Growth Index, 1/1997 through 11/2002, and MSCI US Mid Cap 450 Growth Index thereafter; Small blend—S&P Small Cap 600 Index, 1/1997 through 11/2002, and MSCI US Small Cap 1750 Index thereafter; Small value—S&P Small Cap 600 Value Index, 1/1997 through 11/2002, and MSCI US Small Cap 1750 Value Index thereafter; Small growth—S&P Small Cap 600 Growth Index, 1/1997 through 11/2002, and MSCI US Small Cap 1750 Growth Index thereafter.