Beating the Index
November 14, 2014

Beating the Index

LOS ANGELES. A guard, in suit and tie, asks me to pop the trunk of my rent car. Then I can enter the underground parking lot of a tall building in downtown LA. Upstairs, another guard confirms my appointment. Soon I am admitted to the elevator banks that will take me to the 53rd floor. This is the headquarters of Capital Research and Management. It is the third largest fund complex, with $1.25 trillion under management. But most people know it as the American Funds group.

I’ve come to speak with two researchers from the firm, Thomas Lloyd and Stephen Deschenes. They directed two fascinating research studies. The first demonstrates that the equity-focused funds managed by Capital Research have beaten their target index most of the time. For decades.

Yes, you read that right. Managed funds that beat their comparative index. And they did it often enough, over long periods of time, to be significant. The evidence suggests this is not a Lucky Monkey thing. It’s real value added. I’ll give you some of the data later, but their other research was just as interesting.

The second study asked a simple question, but with rigor. They confirmed data points on mutual fund manager ownership by going through some 20,000 SEC filings. They wanted to make sure their results were clean, without a trace of sample tilting or data mining. Listening to them convinced me.

Here’s their question: How can you screen for superior actively managed funds? The usual answer is: you can’t. At least not with any reliability.

But they found two questions that improved the odds massively.

The questions:
            • Does the fund have expenses lower than 75 percent of other funds?
            • Do the funds managers have significant ownership of fund shares?
            They screened a total universe of 2,466 domestic equity funds. In it, they found 509 funds with costs in the lowest quartile for their category. They also found 447 funds with highest manager ownership. But only 85 funds had both low costs and high manager ownership.

Their data included every ten-year period from 1994 to the end of 2013. In it, they found that only 27 percent of all active funds beat their index. That’s the kind of figure you’d expect from past fund research. Dozens of studies have shown that managed funds can beat their index only about 30 percent of the time.

But the odds were better for low-expense funds (44 percent) and high manager ownership funds (71 percent). And if you combine the two measures, a stunning 100 percent of the funds beat their index. Figures for international funds were similar. In that group 93 percent of funds with both characteristics beat their index. The results were similar, but somewhat reduced, for all rolling 5-year periods.

Yes, it just so happens that low expenses and high manager ownership characterize the American Funds group. This makes their funds a good choice if you want to have the advice of a traditional broker. I have suggested this many times in columns.

The hard part is whether that traditional broker will suggest American Funds. More likely, the broker will offer many less tested and far more expensive products. Why? Simple. The other products will deliver more revenue to the broker and to his firm. If American Funds aren’t offered, it is likely that the broker has focused on his own welfare and pressures from his firm.

What about you? Sorry.

And that brings us back to the first study. They measured the performance of their equity-focused funds in different time periods. The time periods ranged from 1934 through 2012. They found that the American funds beat their index bogies 73 percent of the time over 10-year periods. The odds improved to 83 percent of the time over 20-year periods. And to 98 percent of the time over 30-year periods.

How did other active managers do?  They beat their index 51 percent of the time over 10-year periods. They beat it 42 percent over 20-year periods. And they beat it only 38 percent of the time over 30-year periods.

This confirms what I’ve been writing about for more than 20 years. Most of the time, over most time periods, most actively managed funds fail to beat a simple, low-cost index fund.

As investors you and I face a problem. Thousands of brokers are flogging expensive funds with little management ownership. These funds, most likely, will fail to beat a simple index.

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

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