On MERs and Past Performance (Again)

March 1st, 2015 by Potato

A reader writes in, asking about a particular mutual fund manager. They’ve read The Value of Simple, but aren’t sure if they should switch to DIY index investing considering their particular funds have outperformed net of fees the past few years, and have won Lipper and Morningstar awards.

This was an interesting email to receive. The reader had four different ways of saying that past performance for the particular fund was good.

The Lipper and Morningstar awards are basically useless as indicators of a fund’s ability to out-perform their fees in the future. The Lipper awards in particular are completely focused on past performance, so winning one doesn’t tell you anything a screen of past performance wouldn’t already. The Morningstar award includes “style consistency” and “tax efficiency” as other criteria, but is again basically just a metric of past performance.

There are studies that show that past performance is not a criteria for finding winning mutual funds, so by extension, the Morningstar and Lipper awards shouldn’t have any bearing, either. Indeed, I went back and spot-checked the 2010 Lipper winner, and they badly under-performed in the subsequent ~5 years. Their 10-year average (including the out-performance that won them the award and subsequent under-performance) is now equal to the index. I then quickly checked all the 3-year winners in the Canadian equity category from 2007-2014 (the range data is available from Lipper), and all but one of them went on to under-perform the index. (I didn’t check all of the winners in all categories because they have dozens and dozens of categories to try to spread the love around)

So why is past performance not a good indicator of future performance, when it is for say, job performance for an engineer or a sales associate? There’s always a combination of luck and skill in performance and outcomes, but the proportions change for different tasks. The engineer’s outcomes might be mostly skill and a bit of luck, so a good one in 2010 will probably still be good in 2015. A sales associate might have an equal mix of factors affecting their past performance — finding the skill may not be too hard, but it may not be immediately apparent in past results. But for mutual funds the skill can be completely swamped by luck, so it’s quite hard to find, especially from the customer’s chair.

I’m not dogmatic about indexing and active management, but pragmatic: I think some people can out-perform due to skill, maybe even enough to beat their fees if they do it professionally. However, identifying that small percentage of managers is a task that’s comparable in difficulty to just being an out-performing active investor yourself, and that is very difficult in my mind. You have to have a good understanding of what skill looks like to be able to spot it amongst all the luck and marketing. And the MER acts as a huge hurdle: these guys might be very skilled, but out-performing by even 2% every year is quite an achievement, and that would be needed just get you back to even. In my opinion, going with indexing is the better bet.

Another consideration is what value you get for the MER paid. A big issue in the industry is that typical big bank/big firm advisors just sell funds and don’t provide the detailed plans, hand-holding, tax advice, or other services they claim in newspaper articles are reasons to avoid DIY investing. If you’re getting good service, then you have to decide whether it’s worth 2% — or whatever the fee difference is — to keep getting that level of service, or if you’d rather do it yourself and save on the fees and avoid the risk of their performance streak ending. If you’re not getting good service for what you pay, then paying the higher MER is purely a bet on their ability to out-perform, and historically that has not been a good bet to take. Demand better service to get your money’s worth, or take matters into your own hands (which may include paying fee-for-service for the expertise you need to supplement your own efforts in indexing).

4 Responses to “On MERs and Past Performance (Again)”

  1. Ken Cheung Says:

    I am wondering if you can expand on the past performance, skill vs luck. You use the examples of an engineer and a sales associate. In those cases, you say (and I would agree) that there is a good component of skill that contributes to their performance (past, present and future). However, why is the skill in managing a mutual fund almost ALWAYS discounted? It seems that everyone generically discounts past good performance in mutual fund returns as being due to luck. I don’t get it?

  2. My Own Advisor Says:

    Interesting post.

    I’m of the mindset that since you cannot predict the future, then past performance is all we ever have.

    So, if a long-running track record exists for a MF that has done well over the last 10-20 years, and has beaten the index, then past performance has demonstrated it should continue to do going-forward.

    If there are concerns that MF fees will eat into the portfolios returns then don’t invest in the fund and stick with the lowest-possible cost instead.

    There can be value for fees paid in the financial industry but for the most part, it’s rate.

    Cheers John!

  3. Potato Says:

    Hi Ken, great question!

    The discount is because it’s so hard to tell from the outside what is luck and what is skill. Someone could beat the index for a year and say “hire me, I’m good at picking stocks” and I wouldn’t be able to tell if they were actually good, or if they just got lucky. If I look across the fund industry as a whole, all the people jumping up to say they are good just look like they’re depending on luck — ~80% of them don’t even make enough to cover their fees after 5 years.

    A US stduy suggests that even those who do out-perform for 5 years are no more likely to out-perform for the subsequent 5 years. So the data really seems to fit the view that skill is swamped by luck, and past performance isn’t good enough to pick winners.

    We can think hard about other things that might help us identify skill. Fees (specifically low fees) seem to be a good indicator — if nothing else they lower the bar to beat an index fund, and maybe it says something about efficiency and the alignment of interests. So that’s’s good news for the Mawer/Steadyhand fans.

    Active share is an interesting one. Out-performing funds tend to not be closet index funds — they are more concentrated and avoid duplicating the index top 10. But I haven’t seen studies that show it’s predictive.

    And it’s impractical (and likely not predictive) to try for other measures of skill, like IQ tests or holding 10k footmote reading competitions.

    Anyway, to circle back to the question, I like to think of it in terms of signal processing. If skill is the signal, and the background noise is the influence of luck, then engineering might be like tuning in your local radio station: quite clear and hard to mistake what you’re seeing. With sales you get the obstinante customers and those just looking to buy now, which can skew the results, but you can probably still tell what’s going on, like tuning in CBC at the cottage. In this metaphor, investment managers are like SETI — the skill/signal may be there, but it’s hard to see in all the noise.

  4. Potato Says:

    An interesting related article: http://www.nytimes.com/2015/03/15/your-money/how-many-mutual-funds-routinely-rout-the-market-zero.html?_r=0

    Consistency to the degree of 5 consecutive years isn’t strictly necessary to beat on the long term, but interesting that none of the funds that out-performed from the 2009 start point have managed it.