The New York Times recently ran an article interestingly titled “A Quarter When Mutual Fund Rankings Didn’t Matter” referring to the fact that highly rated mutual funds failed to weather the stock market’s dramatic decline in the 4th quarter of 2008 any better than a portfolio simply representing the market as a whole. A portfolio of Morningstar five-star rated domestic equity mutual funds lost 22.3% in the fourth quarter compared to 21.9% for the S&P 500 index and 22.9% for the Dow Jones Wilshire 5000 index. A portfolio of the top-ranked Value Line, Inc. funds lost 22.2%. This might come as a surprise to some investors, particularly when considering the hefty fees these actively managed funds charge for their purported “outperformance”, or alpha.
Proponents of highly-rated actively managed funds are sounding the popular refrain, “one bad quarter does not make a year”. Their explanation is simply that funds were caught in a violent downdraft that couldn’t be avoided or as the New York Times article quoted, “It’s very difficult in a down market for a fund’s alpha to overcome its beta”. However, the data would suggest that this lack of performance in the 4th quarter of 2008 is anything but an aberration.
As mentioned in a previous post, fund managers have a hard time beating their generic index benchmarks in any type of market with ishares finding that 75% of active fund managers underperform on an annual basis. Furthermore, consider the following analysis referenced in “The Nick Murray Reader” by Nick Murray: “According to Morningstar, one-star funds have outperformed five-star funds by 45% since 1995. If you invested $1000 across the universe in one-star funds in January 1995 and then moved the proceeds each year to the then current crop of one-star funds, your investment would have been worth $2948.54 at the end of 2001. If you pursued the equivalent five start strategy you’d have $2030.48”.
So be wary when considering purchasing the next highly-rated mutual fund. You might be paying five-star fees (according to ICI data, the average actively managed mutual fund has an expense ratio of 1.47%) for performance that can be obtained at a fraction of the price through low-cost indexed investments such as exchange-traded funds.
