Can mutual fund investors beat the market?

FTSE 100 index


Many individual investors employ mutual funds as an alternative to direct ownership of stocks or bonds.

Indeed, mutual funds have some advantages:

  • Diversity: Even a single fund can encapsulate a large sector of the market.
  • Peace of mind: One is less likely to stress out about sudden bad news regarding a particular firm if one owns shares in it only indirectly as part of a large mutual fund’s portfolio.
  • Management fees: Several leading index mutual funds have even lower management fees than corresponding exchange-traded funds (ETFs). And as a class, mutual funds have significantly lower fees than hedge funds.
  • Psychological advantage: Some investors find that mutual funds have a psychological advantage over ETFs, since the ease of selling ETFs often makes it all too easy to unwisely sell them during a market downdraft.

Beating the market

For the reasons listed above, efficiently-operated, low-fee mutual funds often make sense for certain investors. Low-fee index funds are particularly attractive, since tracking a market index is often an entirely acceptable rate of return.

But some individual investors, in particular, believe that they can do better than the market indices, by selecting certain mutual funds that have a track record of beating the market. So how many mutual funds can consistently beat the market, compared with an appropriate benchmark index? Two recent studies raise questions.

Mark Hulbert highlights some recent persistence data from Standard and Poors, which analyzes how many above-average performing mutual funds in one period are able to repeat the feat in subsequent periods.

Here are some results mentioned in the S&P persistence report:

  • Out of those U.S. equity funds that were in the top quartile as of September 2015, only 6.48% of large-cap funds, 1.23% of mid-cap funds, and 6.82% of small-cap funds remained in the top quartile two years later, in September 2017.
  • Out of those U.S. equity funds that were in the top half as of September 2014, only 19.49% of large-cap funds, 18.52% of mid-cap funds, and 23.11% of small-cap funds maintained a top-half ranking over three years, ending September 2017.
  • No large-cap, mid-cap, or small-cap funds managed to remain in the top quartile at the end of the five- year measurement period.
  • Only 4.73% of large-cap funds, 6.47% of mid-cap funds, and 5.49% of small-cap funds maintained top-half performance over a five-year period, ending September 2017. A coin-toss experiment would suggest the figure (1/2)^6 = 6.25%.

Paul Merriman highlights the SPIVA report, also from Standard and Poor, which analyzes the performance of actively managed mutual funds, compared with the S&P Small Cap 600 index (for small-cap U.S. stocks), the S&P MidCap 400 index (for mid-cap stocks), and the main S&P 500 index (for large-cap stocks).

Here are some results from the S&P SPIVA report:

  • During a one-year period (i.e., 1 July 2016 through 30 June 2017), only 43.44% of large-cap managers, 39.31% of mid-cap managers, and 40.45% of small-cap managers outperformed their respective index.
  • Over a five-year period (i.e., 1 July 2012 through 30 June 2017), only 17.62% of large-cap managers, 12.79% of mid-cap managers, and 6.17% of small-cap managers outperformed their respective index.
  • Over a 15-year period (i.e., 1 July 2002 through 30 June 2017), only 6.82% of large-cap managers, 5.60% of mid-cap managers, and 5.57% of small-cap managers outperformed their respective index.

Hedge funds

Mutual funds are not alone to have difficulty in exceeding market indices. As we have described in a previous Math Investor blog, most hedge funds also have been lagging the market averages. For example, as of 1 July 2017, the HFRI Fund Weighted Composite Index is up 4.79% (annualized gain) for the previous 5 years. The corresponding figure for the SP500 Index (including dividends) is 13.6%.

Some hedge funds do consistently beat the market indices. But according to Institutional Investor’s Alpha, most of the hedge funds that consistently achieve above-market results rely all or mostly on computers and algorithms to make their investment decisions — these are not traditional actively managed hedge fund operations.


It is disappointing not to see some more evidence of skill in selecting securities for mutual fund portfolios in actively managed mutual fund data. In fact, the statistics we have cited above are very likely on the optimistic side, because of the well-known “survivorship bias” phenomenon — over the years numerous less-successful-than-average mutual funds (and their managers) have ceased operations, and are therefore not included in these statistics; if they were, they would drag down the performance statistics even more.

Some funds, both mutual funds and hedge funds employ technical analysis and related techniques — charts, graphs, waves, etc. But as we have shown in a previous blog, such techniques have no scientific basis, and indeed, there is no evidence in empirical data of such techniques working.

We should not be terribly surprised by any of these results. As we have pointed out in previous blogs, markets by definition incorporate the collective judgments of many thousands of highly trained market analysts worldwide, many of whom now employ powerful supercomputers connected to satellite, econometric and social media datasets, using sophisticated mathematical algorithms and high-frequency trading facilities to act on these phenomena in real time. The efforts of these many players largely cancel each other out, leaving a time series that is little more than a random walk.

So mutual fund managers who have difficulty consistently beating the market averages should not feel bad — they are trying to find profit in a signal that is almost entirely random noise.

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