No one can consistently outperform the market
Study says managers’ ability to beat the market is as cyclical as the Street itself Mark Hulbert Few mutual fund managers beat the stockmarket over the long term. That sad truth is widely understood, and it helps to account for the vast popularity of index funds, which aspire only to match the returns of a particular market. But a new study suggests that it may be too soon to give up on actively managed mutual funds. While few managers can outpace the market as it moves up and down, year in and year out, substantial numbers can predictably outperform it during parts of the economic cycle, the study has found. The study, called ‘Investing in mutual funds when returns are predictable’, is forthcoming in the Journal of Financial Economics. In the past, the study says, most mutual fund research assumed that managers’ ability or inability to outperform the market was constant, regardless of the waxing and waning of the market cycle. But the study made a different assumption: that significant numbers of managers may have market-beating abilities at some stage of the economic cycle, but not at the others. A manager, who can beat the market during a recession, for example, or in periods of high inflation, may well lag behind it in periods of robust economic growth or low inflation. The study specifically correlated funds’ returns with four macroeconomic variables that previous studies found to be good leading indicators: the 90-day Treasury bill rate, the stock market’s dividend yield, the difference between the interest rates of junk bonds and higher-quality issues (the so-called default spread) and the rate difference between longer-term Treasuries and 90-day Treasury bills (the term spread). How can this help investors beat the market? To find out, the study built a hypothetical portfolio that invested each month in the no-load funds that historically performed the best when the four macroeconomic variables were similar to that month’s readings. They back-tested the portfolio from 1980 through 2002, using only the information that was publicly available in each month. The study also compared their portfolio’s gain with that of several strategies that previous research had found to have market-beating potential. None of those others came close. The professors’ strategy does come with significant caveats about its real-world profitability. Because the portfolio is rebalanced monthly, it can require frequent switching among funds. According to Professor Wermers, the average holding period of funds in the portfolio was only about four months, so almost all the capital gains would be taxed at the higher short-term rate. That means the strategy works better in tax-deferred accounts. And what happens if a fund under consideration imposes huge fees or other restrictions on frequent short-term trading, as some funds have started to do? In such a case, the professors would simply avoid the fund. After all, Professor Wermers says, there are still plenty of funds that don’t have such restrictions but do have managers that can beat the market during part of a cycle. The study concede that their strategy is probably more appropriate for institutions than for individual investors. Still, it can teach us not to be too quick to conclude from the fund industry’s dismal long-term record that virtually no managers have market-beating ability.— NYT News Service
