How do mutual funds benchmark with dead funds added back? (5th in Series)

In aggregate, the average mutual fund in virtually every asset class, underperforms its benchmark during almost every measured time horizon. The obvious question is, “Why do active mutual funds continue to exist?” Of course, the reason is that in our performance culture, all the managers and firms believe they will beat their index. This aligns well with investors who are exposed by several decision-making biases including, performance chasing and believing they have the skills to spot winners.

Before looking at how active managers perform versus their benchmarks, let’s look at the real-world fact of mutual fund survivorship. Per the S&P Dow Jones data used in this section, over the 15-year period from 2003-2017, mutual funds were liquidated or merged into other funds at a surprisingly high rate. During this period, the disappearance of mutual funds was as follows: 58% of domestic equity funds, 55% of international equity funds, and 48% of all fixed income funds. This SPIVA study uses a mutual fund database that ‘adds back’ funds no longer in existence, as if they were in place and underperforming the benchmark during the entire period.

As the table below illustrates, picking an active fund manager (in advance) to beat their index is worse than a coin toss for any given one-year period. For longer periods of time, as outperformance approaches 100% in some cases, investors or fund managers who believe they will ‘beat the market’ are suffering from a fairly bad case of delusion. This is especially true for domestic equity managers. This makes sense, because U.S. stock are probably the most researched and traded securities on the planet. It's logical that they’re efficiently priced. Of course, all active fund managers are already behind before they even get started due to the management fees they must charge to pay for the staffing, marketing, regulatory, and trading costs they incur that are not present in the benchmark indexes.

Careful examination of this table shows there may be some asset classes where active management may have an edge over their benchmarks. First, the complexity of international equity markets appears to benefit those active managers versus their domestic equity counterparts. If an investment management firm has the resources to maintain an international research staff, they have a better chance to uncover opportunities not captured by broad international market indexes.

Second, while there is literally no edge besides timing for active government bond fund managers, corporate bonds appear to be a less efficient market. Short and intermediate-term Investment Grade Corporate active managers, as well as Global Fixed Income managers, appear to be able to take advantage of their market’s higher inefficiency. Fixed income markets are more thinly-traded and have negotiated, over-the-counter pricing. In addition, fixed income managers have the ability of holding cash and reducing their risk by lowering their portfolio’s duration.