After a rather tumultuous decade in which the overall performance of 401k plans is best described as anemic, we may be entering a period of redemption that could have 401k plan sponsors and participants smiling again. But the recent financial storm has left the waters somewhat murky, and plan sponsors or their investment committees should wade carefully in their search for the next decade’s top performing investment funds. However, scouring the past performance tables for indications of future leaders may no longer be a viable method for selecting funds.
This is not to say that past performance is a completely useless gauge. There is still some important information to be gleaned from history. However, a closer look at how mutual funds have performed in recent history, relative to their past performance, should give one pause as to its reliability as a selection tool. When used in conjunction with other more critical information it can certainly paint a much clearer picture.
Performance We Can Believe In?
Let’s start with the fact that the last decade produced very few repeaters. That is, of the funds that, at one point, achieved a top half ranking, less than 5 percent were able to sustain that ranking consecutively over a five-year timeframe. The poster child for non-repeaters has to be the Apex Mid Cap Growth Fund which topped out with a mind-boggling 165 percent return in 2003, but managed to also lead its category with the worst fifteen-year annualized return of minus 8.17 percent. The obvious lesson here is that chasing top performers may be harmful to your financial health.
In the 1960s, University of Chicago professor of economics, William Sharpe conducted extensive research on stock price patterns, which led to his development of the Efficient Market Hypothesis (EMH).1 The EMH maintains that market prices fully reflect all available information and expectations, so current stock prices are the best approximation of a company’s intrinsic value. Attempts to systematically identify and exploit stocks that are mispriced on the basis of information typically fail, because, according to the EMH, stock price movements are largely random and are primarily driven by unforeseen events. Although mispricing can occur, there is no predictable pattern for their occurrence that results in consistent outperformance.
The bottom line is that active management strategies using stock selection and market timing cannot consistently add value enough to outperform passive investment strategies. However, mutual fund managers are insistent on testing the theory by earnestly trying to pick the winners and time the markets. Clearly, their results have yet to prove their real worth to investors.
Year after year, reporting by mutual fund tracking services, such as Morningstar, reveals that the majority of actively managed stock funds fail to beat their benchmark indexes; and those that sporadically do beat the market, a miniscule number have been able to consistently repeat the feat. This is hardly surprising to academia that has, time and again, shown that, as a whole, active fund managers typically underperform the indexes at least by the amount they charge in fees and expenses.
The EMH concludes that, because of the short-term randomness of returns, investors would be better served through a passive, structured portfolio based on asset class diversification to manage uncertainty and position the portfolios for long-term growth in the capital markets.
For plan sponsors, who must exercise prudence in selecting investment options, the justification for paying higher fees for actively managed funds is becoming a much heavier burden to bear. As investment options, more passively managed funds may not seem very exciting; however, their market-tracking performance is certainly easier to explain and justify over the fee-laden performance of actively managed funds, which, as a whole, has been mediocre at best.