Since the inception of the stock market, investors have searched for one thing endlessly: alpha. The quest for returns above the market index rages on today stronger than ever. And every year or so, a new mutual fund comes out touting amazing, overachieving returns, becoming the new hot thing. But what happens next to these overachieving mutual funds?
Most recently this was Cathy Wood’s ARK fund, which famously predicted Tesla would rise to $2,000. And for many years, her fund provided above market index returns.
This is all well and good. But only if the fund can maintain those returns over the long term. This is called persistence. And we should be investing for the long term. So, if a fund can’t maintain alpha with persistence, it really serves no purpose.
Why is this an important exercise?
Because, going back to the ARK fund, even more famously, it has now lost investors money overall.
And this is not a new phenomenon
Instead it’s a situation where those who do not know history are doomed to repeat it.
With that back drop, I’d like to share some case studies of 4 very famous overachieving active mutual funds that ultimately failed to maintain returns long term.
And because streaks happen
Did you ever play the video game NBA Jam back in the day? In the game, if one of your players hit a few 3 point shots in a row, they became “ON FIRE.” And basically they were much more likely to hit the next shot.
Unfortunately, that’s not how life works. In fact, one statistician studied a basketball team for an entire season. And the odds of a career 50% shooter of hitting their next shot were 50%. Whether they had just made the previous 5 shots or missed them.
Nobody, not even LeBron, gets the NBA Jam treatment.
And here’s a more clinical example: If you flip a coin 20 times, the odds of getting a heads or a tails four times in a row is 50%! I’m willing to wager that’s way higher than you would guess. It’s certainly higher than I would have!
This is all to say…
Just because a certain fund overachieves the market index doesn’t mean that it’s because of skill or some other active factor. And just because it happens the next year…and maybe even the next…doesn’t mean that either.
Because return to the mean (or in this case, return to the index) is the rule, no mutual fund has demonstrated persistence of higher than index returns over the long term more than that expected by chance alone.
And misconstruing luck for a hot streak can be very dangerous to your wealth. That’s speculating, not investing.
So, let’s look at our case studies of overachieving funds…
4 overachieving mutual funds that failed to maintain returns
Let’s start with the mother of all overachieving mutual funds…
And shout out to The Quest for Alpha by Larry Swedroe for introducing me to these funds!
The 44 Wall Street Fund
In the 1970s, David Baker’s 44 Wall Street Fund was the best performing U.S. stock fund, even more than Peter Lynch and his more famous Magellan fund.
And after 10 years of beating the market, what happened next? Well, if you investing in the S&P 500 over the following 10 years, you received over $5 for each $1 invested. But, if you invested in the 44 Wall Street Fund over the same time period, each $1 invested turned into $0.27. Yikes!
That’s a lot more years of needing to work as a reward for trying to jump on the bandwagon that ended up being just another hot streak.
After that disaster, this fund was bought out and ultimately merged into another.
The Lindner Large-Cap Fund
For 11 years from 1974-1984, this fund beat the S&P 500. But then, over the next 18 years, investor saw returns of just 4.1%. This was an underperformance of 8.5% per year compared to the 12.6% that the S&P 500 returned.
Not good. Another fund bought and merged and lost to the history books.
But you might be saying, what have you done for me lately? So let’s look at a more recent example.
The Legg Mason Value Trust Fund
Now there’s a name you can believe in!
By end of 2005, this fund run by Bill Miller beat the S&P 500 a whopping 15 years in a row! Truly incredible. But was this just luck or some skill?
Unfortunately, believers that past performance predicts future performance got burned. And got burned quick.
In 2006, the fund underperformed the index by 10%. Then by 12% in 2007. Couldn’t get worse than that, right? Well, it did. In 2008, the benchmark S&P 500 beat the LMVTF by 18%.
And to be fair, in 2009, he did beat the benchmark again. And also to be fair, I’m sure there were plenty of investors willing to bet that this time would be different.
One last example…
The Tiger Fund
This one is actually a hedge fund. But it still helps illustrate our point.
This fund formed in 1980 by well-respected investor Julian Robertson. And in its first 18 years, it averaged returns of more than 30% annually! In 18 years, it amassed more than $22 billion in capital from its original $10 billion.
Unfortunately, from that point on, it fell to next to nothing with over $10 billion lost from peak to closing.
But here is the even more interesting part, even while the overall fund showed lifetime returns of 25% per year, the majority of investors in the fund lost money. How can this be? Well, it can be because most money come into the fund late, after the great returns and spoils were enjoyed.
This is an important lesson for anyone looking at past returns. While not predicting future performance, they can also be quite deceptive in describing the past performance itself!
If these overachieving mutual funds (and one hedge fund) can’t provide persistent greater returns, what ones can?
None. Yes, we cherry picked these examples. But history is full of them. And long term data in peer-reviewed journals support the anecdotal evidence provided here.
However, just like in medicine, anecdotal case reports do carry merit. Because they can provide such illustrative examples of overall truths that we remember them better.
So, my advice to you is to remember this: no active overachieving mutual fund maintains greater than benchmark returns at a rate better than that predicted by chance alone.
Not even institutional funds with tons of fancy computers and algorithms and experienced managers. So, while not impossible, the odds of you doing it are very low. Low enough that you shouldn’t try.
Here’s what to do instead
- Create a savings rate of at least 20%
- Build a basic goal asset allocation of stocks and bonds
- Re-balance back to your goal asset allocation yearly
- Invest passively to capture market returns via index funds
- And then, if you ever get bored of index funds, ignore the noise and do any of these 7 things instead of straying from your plan!
In the meantime, check out my underdog origin story from financial cluelessness to well-being or watch my Masterclass Webinar on The 12 Steps to Financial Freedom for Physicians here!
What do you think? Are fad funds consistently able to beat the market? Have you ever invested in an actively managed mutual fund? How did it do? Let us know in the comments below!
