Is Using Active Investment Management a Fiduciary Breach? - Part Three

In this series we are considering whether there are clear indicators or “signposts” that investors can follow to decrease their chances of selecting investment managers, typically mutual funds, which will underperform their peers and appropriate benchmarks. We say “decrease their chances” because, as overwhelming evidence shows, for the most part active investment managers fail to make good on their (implicit) promise to outperform.

Significant manager ownership of a fund as signpost for reduced risk

In our last post in this series we examined, and found wanting, a claim that funds managed by the largest mutual fund complexes have a greater likelihood of delivering index beating returns than the broad range of funds. In this, we examine a second claim: That funds with a high level of manager ownership, specifically over $1 million by one or more of a fund’s managers, is an indicator of likely superior – index-beating – return capabilities. (For even more, check out American Funds Distributors' Capital Idea: Expect More from the Core.)

Starting with the same initial universe of large cap domestic equity mutual funds with at least 30 years of performance history we derived from Morningstar Advisor Workstation (see again Part Two of this series), we applied an expanded manager ownership criterion that included funds with at least one manager or combination of managers having at least $500,000 invested in their fund. This reduced the field of candidates from 76 funds to 45 using manager ownership data as of March 31, 2016. We acknowledge that high manager ownership now may not accurately represent what was the case during the eleven periods we measured. However, given the data resource constraints of “readily available” and “reasonably priced” we laid out previously, we allowed for the possibility of cultural ethos of ownership.

Here’s what we found:

21 funds, 47%, outperformed the S&P 500 in 7-of-11 periods evaluated;10 funds, 22%, outperformed in between one and six periods;14 funds, 31%, didn’t outperform in any period evaluated.

In other words, 53% of funds with at least $500,000 of manager conviction invested in their funds failed to earn a grade of D- against the S&P 500 over 11 periods covering 20-to-30 years of comparative performance. Not, in our view, a clear signpost for anyone seeking to reduce the chances of selecting managers who underperform.

What other signposts might be considered?

What, then, are we left with as means to lessen our chances of selecting funds and managers who underperform? Both studies acknowledge low fees, in the form of fund expense ratio (and to some extent turnover) is a significant factor in identifying funds less likely to underperform. 

In our next post, we’ll describe how we applied this criterion and what we learned.