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For years, the big business of a mutual funds rating system has been offered by a few organizations, but with the arrival of the internet, business has become quite large. Morningstar is probably the largest and most relied-upon, but there are many others, some not quite as reputable.
The most familiar (and most used) component of mutual fund ratings is “past performance.” A past performance rating system essentially groups mutual funds’ historical returns into classes. The funds that have returned the highest net returns for their investors are rated at the top of the class. The lowest performing funds are, of course, on the bottom.
On the surface, the practice of using past performance as a primary factor seems like a good idea for the investor, giving assistance on which mutual fund investments to purchase. But underneath, things aren’t quite as neat and tidy as they seem.
Author Burton Malkiel in his book “A Random Walk Down Wall Street” published first in 1973 (by the way, if you haven’t read it, you need to) gives a wonderful illustration regarding probabilities and chance when it comes to investing. He simply offered the suggestion that just because a fund outperformed its peers for a few years in a row, didn’t necessarily mean that the out-performance could be completely attributed to fund manager skill. He believed that chance was at least part of the driver of success, and offered a wonderful analogy for us to follow.
Let’s use his analogy and update the numbers for our current times. As you read the parallel, keep in mind that the coin-flippers are likened to the 8,000 mutual fund managers who buy and sell securities for the mutual fund hoping for better performance than their peers.
Analogy
Imagine a very large room that contains 8,000 coin-flippers preparing for a coin-flipping contest. The rules are simple. All of the coin-flippers flip at the same time. Those who consistently flip heads will be declared winners and will advance to the next round. Those that flip tails are considered under-performers and will not advance to the next round. Contestants will flip for 10 rounds until we have our winners.
On the first flip, it appears that we have 4,000 winners, as would be expected. The second flip reveals that 2,000 of those are winners. The third flip eliminates another 1,000. The fourth flip gets rid of 500, the fifth, 250. So after five flips there remain 125 “skilled” men and women waiting for the sixth flip.
It is at about this time that the crowd begins to see that these “head-flippers” really are rather extraordinary. The flippers’ expertise does not go unnoticed. They are now getting book-deals and appearing on CNBC passing on their wisdom to us mortal investors.
The competition continues until a total of 10 coin-flip contests have transpired. We are now left with 7 coin-flipping geniuses. They have beaten their coin-flipping peers 10 times in a row. WOW!
Summary
Can you see the analogy? In 2008, investors had access to some 8,000 mutual funds, analogous to the number of contestants in the above illustration. Using a 10-year mutual fund rating system, there would certainly be those mutual funds that would rise to the top, even if only by chance.
This illustrates the problem with mutual fund ratings that rely so heavily on past performance. There is no sure way to evaluate if the performance of the fund was generated by skill or luck. Besides, can we say with certainty that mutual fund skill even exists?
Since we have no definitive way to measure the skill of the mutual fund manager, we should not let our primary focus on mutual fund quality be on the past performance of the mutual fund.
Instead, mutual fund rating companies and advisors should focus on the measurables that we know. Mutual fund expense ratios, loads, and turnover are matters that can be controlled by mutual fund companies. And in the long run, this is where rating mutual funds should focus.
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