Good(?) news, mutual funds perform better in recessions than expansions

Before we get to the good(?) news let’s run through what we know about mutual funds:

1. Studies have shown that actively managed mutual funds have a structural    disadvantage as compared to index funds or (index) ETFs. The mutual fund manager must overcome the fundMER(Management Expense Ratio differential) as well as the excess trading costs and taxes associated with the higher turnover of an actively managed fund.

2. In fact studies have shown that active managers’ skill in stock selection on a sustained basis is insufficient to overcome the drag associated with the structural disadvantage and that doesn’t even include the effect of survival bias (i.e. the really poorly performing funds go out of business and are not in the sample analyzed). The 1983-1993 sample space of large company funds in a recent study, the 27 0f 171 funds that outperformed the S&P500 index have on the average underperformed the index in the next 10 year period of 1993-2003 at 9.85% to 10.56% before tax and 8.34% vs. 9.94% after tax. Also for the 1983-2003 sample space 72-88% of actively managed mutual funds underperform the S&P500 index. So the probability of selecting the future outperforming funds is very low. You can read the entire McGuigan study at “The Difficulty of Selecting Superior Mutual Fund Performance”in the February 2006 issue of Journal of Financial Planning.

3. This “What’s New” was actually triggered by Ken Kivenko’s   January 2007 newsletter sent to me by a friend (Ken is an investors’ advocate trying to bring visibility to all that’s wrong with Canadian Mutual Funds; if you still own or plan to invest in mutual funds look at his website is at http://canadianfundwatch.com/). In his newsletter he refers to a piece by Chris Holt at Seeking Alpha http://etf.seekingalpha.com/article/23225on an interesting study by Kosowski which shows that “US mutual funds actually perform better during recessions than they do during economic expansions”. This could be a compelling reason to buy actively managed mutual funds rather than the index, especially at the start of a recession. But Holt goes on to argue that in order to take advantage of this phenomenon the investor would have be a good market timer (not considered a generally successful approach to investing). Also, if you assumed good market timing was possible than investor could go short the index and/or just reduce index in his asset allocation (rather than use mutual funds). So Holt concludes that “Absent any market timing skills, the patient mutual fund investor is still destined to receive the average performance of mutual funds over both expansions and recessions”, i.e. underperform the corresponding index.

4. Studies have in fact shown that the average mutual fund investors’ skill and behavior is such that he doesn’t even receive the average performance (i.e. he tends to buy the previous good performers after they have been recognized as such and the sell them after they become poor performers- buy high and selling low). Here is a quote from David Quill in his 2001 article entitled “Investors Behaving Badly: An Analysis of Investor Trading Patterns in Mutual Funds” “This excessive turnover, combined with a propensity to buy relatively over-valued investments and ignore relatively under-valued ones, has caused the average mutual fund investor to underperform substantially over the past decade.”

5. And finally add the crippling fees associated with Canadian mutual funds as reported for example in a Globe and Mail article by Steiner entitled “Why do Canadians pay the world’s highest mutual fund fees?”

The question then remains why would you buy or hold actively managed mutual funds (other than perhaps you have a large accumulated capital gain and corresponding tax liability that you don’t want to deal with right now)? The average investor over the long run underperforms the index, especially inCanada. Whether the Total Shareholder Cost(TSC) reported in the last referred to study is as wide between Canadian funds at 4.7% vs. 1.7% in the U.S., since study included sales commission to fund seller, the differential is still known to be painfully significant.