Math can unlock the world for us. But only if we use it accurately.
A quick lesson today on investment performance. Apologies if I end up being soap-boxy. But bad math (especially by experts) ruffles my feathers.
To start, it’s high time The Best Interest deploy the didactic use of:
“There are three kinds of lies: lies, damned lies, and statistics.”
Mark Twain (?)
You might have seen a headline like this before:
[Here’s that NYT article if you’d like to read it yourself]
The conclusion of the article is straightforward: actively-managed mutual funds largely fail to outperform simple index funds. Therefore, avoid actively-managed funds.
I largely agree with the conclusion. That’s why a significant portion of my investments are in index funds. But as always, the devil’s in the details. And in this case, those details are hiding an important truth. In fact, the New York Times gets their math dangerously wrong.
Here’s an excerpt from the article above, written by the NYT’s Jeff Sommer:
Over the last five years, not a single mutual fund has beaten the market regularly, using the definition that S&P Dow Jones Indices has employed for two decades.
Ouch. That’s stunning. Sommer continues…
The S&P Dow Jones team looked at all the 2,132 broad, actively managed domestic stock mutual funds that had been operating for at least 12 months as of June 2018.
The team selected the 25 percent of the funds with the best performance over the 12 months through June 2018. Then the analysts asked how many of those funds remained in the top quarter for the four succeeding 12-month periods through June 2022. [Emphasis my own. -Jesse]
The answer was none.
Not a single one of the initial 2,132 funds managed to achieve top-quartile performance for those five successive years. That hasn’t happened for stock funds since 2011. This time, S&P Dow Jones Indices did the same measurements for fixed-income funds and came up with the same result: zero. Not a single bond fund remained in the top quarter for every 12-month period.
In other words, this study queried: how many mutual funds beat more than 75% of other funds in each of 5 straight years, 2017 – 2022? Answer: none.
The average person might say, “Well shit! All the more reason to drink the passively managed Index Fund Kool Aid!”
Go ahead and drink. It won’t hurt you. Index funds are great. But the NYT is (probably unknowingly) using terrible, misleading math. It’s the third kind of lie from Twain’s quote. Bad stats and bad math obfuscate a more important, nuanced truth.
Why does it matter? Why do I care?
Because I’m playing the game called ‘Long-Term Compounded Returns.’ If you’re reading this blog, I bet you’re playing that game too.
We’re not playing a game called ‘Be In the Top 25% Every Year’. Who cares if a fund remains in the top 25% for 5 straight years? What if the fund was in the top 1% for 4 years (amazing!), and then only average in the 5th year? This study gave that fund a thumbs down.
(PS – why are we measuring stock portfolios on a 1-year basis, anyway? Stocks are not a short-term asset class)
It’s pure folly.
Portfolio performance is the product (e.g. multiplication) of many years’ results. Being told that a fund underperformed in at least 1 of 5 years tells me nothing about the cumulative performance.
Here’s an example:
- For 9 years, the S&P 500 plods along. Fund A outperforms the S&P by 1% per year. And Fund B underperforms by 1%.
- But in Year 10, something weird happens. The S&P drops 20% – a bear market. Fund A gets hammered, dropping 40%. Fund B weathers the storm better, dropping only 5%.
Pop quiz: which fund had the best 10-year performance? Based on the data shown in this chart, the performances are:
- S&P 500 = +9.1% per year
- Fund A (orange) = +6.4% per year
- Fund B (gray) = +9.6% per year
But if we’re measuring only on year-by-year performance, Fund A would be the shining star. It beat the market in 9 out of 10 years. And Fund B, having underperformed for 9 straight years, would be outcast.
For the third time in two years on the blog, I’m invoking this particular Howard Marks quote:
I feel strongly that attempting to achieve a superior long term record by stringing together a run of top-decile years is unlikely to succeed. Rather, striving to do a little better than average every year — and through discipline to have highly superior relative results in bad times — is:
– less likely to produce extreme volatility,
– less likely to produce huge losses which can’t be
recouped and, most importantly,– more likely to work (given the fact that all of us are
Howard Marks
only human).
For what the NYT hoped to express, the only metric that matters is cumulative performance. (Risk doesn’t matter, ostensibly, because it’s been adjusted for. All 2132 funds in the study hold a broad selection of domestic stocks and share a similar risk profile.)
That’s why I prefer SPIVA data over what the NYT reported. SPIVA compares across cumulative performance.
SPIVA shows us that in developed economies with efficient markets (like the US), it’s hard to beat the market over long periods of time. You can do it, but it’s probably not worth trying.
In developing economies with inefficient markets, active management becomes worth discussing. This is a nuanced conclusion that the NYT glossed over. In fact, indexing would fail to work correctly without active managers. This is part of the argument behind the index fund bubble.
Math can unlock the world for us. But only if we use it accurately.
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-Jesse
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