Luck and Skill Investment Strategy When Picking Mutual Funds

When it comes to an investment strategy, why not just pick a handful of the top-performing mutual funds and then rely on the talent of top mutual fund management team, correct?

Not so fast! There are some great research studies that can demonstrate that when it comes to the investment performance of mutual funds — it’s luck that counts the most. 

investment strategy - two people discussing graphs in table - webIn the end, working with a portfolio manager who looks at the entire picture of your financial future – and who constructs your portfolio with an eye on how much risk exposure you want (and how the market forces are working) may be a wiser choice. 

Some studies (see links below) in the past few years have some interesting points about whether skill is stronger than luck when it comes to beating the market with mutual funds. 

The Momentum Effect is … Meh

A common strategy for picking mutual funds is to go with the momentum investing model. In other words, go find an actively managed mutual fund — one for which managers select stocks — that beat the market the previous year. Momentum investing has been the ongoing model for selecting mutual funds for the last few decades; many cite a study by Mark Carhart, who studied mutual fund returns from 1962 to 1993.

A new study, “Did Mutual Fund Persistence Persist?” follows directly in the footsteps of Carhart, but this time examined what happened from 1994 until 2018. The answer: the momentum effect didn’t exist anymore. Other recent studies point to some reasons why.

Picking Talent is Not an Investment Strategy

investment strategy - man showing graphs in paper to womanLots of marketing language for mutual fund companies will heap praise on the skill and training of the mutual fund managers. You get the feeling that you are actually paying for the high salaries of superstar managers – and it will be worth it to pay more for top talent.

The study “Scale and Skill in Active Management” thwarts that argument. Researchers point out that even when the mutual fund managers are skilled, the same skill levels are seen across the board in the mutual fund industry. So, there is no advantage in paying for the salaries of an all-star team. 

The researchers summarize their findings:

As the size of the active mutual fund industry increases, a fund׳s ability to outperform passive benchmarks declines. At the fund level, all methods considered indicate decreasing returns, though estimates that avoid econometric biases are insignificant. We also find that the active management industry has become more skilled over time. This upward trend in skill coincides with industry growth, which precludes the skill improvement from boosting fund performance. Finally, we find that performance deteriorates over a typical fund׳s lifetime. This result can also be explained by industry-level decreasing returns to scale.

Re-Sorting the Stocks

man looking at investments on wallAnother study points to the impact and randomness of stock rebalancing – and how it just creates a dumb luck effect on fund performance. Or, think of it as a huge roulette wheel. In the study “Rebalance Timing Luck: The (Dumb) Luck of Smart Beta”  researchers point to the impact of how often funds rebalance and shift around their stock holdings. Funds regularly engage in rebalancing mutual funds (usually based on an automated system set by the fund’s investment strategy) to its target allocation. Rebalancing is done by divesting in underperforming assets and investing in the stocks that follow the fund’s goals (ie: growth, value).

The timing of rebalancing varies according to each fund. But the shifting market forces make it hard to analyze the performance against benchmarks.

They concluded:

Our results suggest substantial problems for analyzing any investment when the strategy, its peer group, or its benchmark is susceptible to performance impacts driven by the choice of rebalance schedule.

So What to Look For?

investment strategy - older man analizing papers - webInstead of trying the NBA model (ie: pick a winning mutual fund and betting on its future success), there is another holistic approach to investment strategies. 

A portfolio manager looks at the complete picture – covering factors such as market forces and retirement time frame – when creating a portfolio for clients that can include mutual funds as well as other investment options for balance and risk management. As the market shifts amid the tumultuous 2021 events, our portfolio managers scale their perspectives to meet our clients’ needs. We realize that a nimble, customized approach is the key during these … well, interesting times.

As Justin Thomas, one of our managing partners noted in a recent column about the market gains in the last month:

But while we don’t know when the music stops, we do know what happens. And it won’t be pretty. Of course, that’s where Stableford comes in. We are aware of these factors. Our goal is not to be tied to one viewpoint, be it perma-bear or perma-bull, but to take measure of all views and set a prudent course.

Talk to our experts about your needs by contacting our team at Stableford. For more in-depth analysis during these interesting times, request a trial subscription to our digital market blast.

Andrew Brinkman
Andrew J. Brinkman is the Founder of Stableford Capital. Over the course of his 45+ year career, he built A.J. Brinkman & Co., a leading foreign exchange arbitrageur and institutional floor broker, was a managing partner of Petros Capital, a long/ short institutional hedge fund and, for the past ten years, he has been a discretionary asset manager for high net-worth families. Andrew Brinkman has been a member of the Chicago Mercantile Exchange, the New York Futures Exchange, and the Chicago Board of Trade. A 1978 graduate of Cornell College with degrees in Economics and Political Science, he was a board member for ChildHelp USA, a board member of the Berry Center for Economics, and former trustee of Cornell College.

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