Sunday, August 15, 2010

The Best Predictor of Fund Performance

A desire to know the future is universal and ages-old.  In matters involving human behavior, attempts to fulfill that desire are - unfortunately - unrewarding.

Something in our brains desires to know what will happen in markets, which are driven by human behavior, and desires to hear the views of people who are supposed to (or who profess to) have foresight. But unless one likes being wrong often - or can profit from predicting, notwithstanding outcomes - one shouldn't predict the stock market. The best response to the constant question of what the stock market "will do" is J. Pierpont Morgan's response: "it will fluctuate." Over the truly long term equity prices tend to rise; except for that tendency equity market moves are mostly noise and little signal. And what is noise and what is signal is inherently indiscernible.

As a result, predicting stock market direction is folly. So is giving credence to those who do. Columnist Scott Burns: "All we can do is cultivate flexibility, diversify our savings and share as little of our return as possible with those who claim to know the future." [Emphasis added.]

Do not invest in actively managed mutual funds including because their underpinning is their managers' supposed ability to predict stock winners. Actively managed mutual funds are for fish.

Those who believe in fund managers' supposed predictive abilities - and who consider actively managed mutual funds fitting vehicles to share the gains resulting from those abilities - are advised to consider new data from Morningstar (linked below). The data yield an interesting conclusion that may not be intuitive but which follows from the points of view above. That conclusion isn't that the best predictor of mutual fund performance is a manager's track record, tenure, or education, or a fund's "fund family" or "investment style," etc. The best predictor is one simple data point: a fund's expense ratio.

Addendum 8/29/10:  a NYT article about the same Morningstar data is available here.

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