I have some questions about the stock market and maybe somebody out there has the answers handy. If not, I’ll start bugging some of my economist resources out there in the blogosphere and report back. You frequently hear it claimed that, on average and over time, investments in equities have earned about 8%. I don’t have any problem believing that. I also believe that those earnings come largely in big spikes (like the one we’ve just been through) rather than a regular year-to-year 8%. In the period between 1965 and 1981 there were no earnings from investments in equities (on average) IIRC.
So here are my questions. Do mutual funds—taken as a whole—mimic the behavior of the market? How about some small (but prominent) selection of mutual funds? How about a single mutual fund?
My intuition into this is that mutual funds taken as a whole probably don’t mimic the behavior of the market that well. And that any small group of funds or a single fund is even worse.
Does anybody know about this stuff? Or have any references?
For a specific fund, it depends on the fund’s design. A fund invested exclusively in large cap domestic stocks may be a reasonable reflection of the Dow. Most funds have specialties, and to the extent that those specialties are not correlated with the overall market, those funds will diverge. A S&P 500 index fund by definition will follow the market (as measured by the S&P 500). An international fund will not.
Taken as an entire group, mutual funds likely reflect the broad set of investment strategies of investment players, so I would guess that there is some sort of correlation. Mutual funds, however, are also run by managers that charge fees. One of the fascinating empirical studies I read about awhile back showed that mutual fund managers outperform the market — on average — just about enough to justify their fees and no more. This is why there has been a push for Index funds … they are “brainless”, but they also don’t churn stock as rapidly. They therefore deliver the “market” return … or almost … and that’s about as good as you can expect to do with mutual funds.
Victor is right. For funds that operate more or less in tune with the market trends themselves index funds can’t be beat. They purchase stocks of everything on the S&P, or one of the other broad market groups, equally. This means as the S&P goes up, or the Nasdaq goes up, the index fund follows it.
Mutual Funds are more specialized, and often target particular sets of industries expected to boom. The problem with a lot of Mutual Funds (to the great chagrin of my parents, who lost hundreds of thousands of dollars) is that because they targets sets of boom industries often as they go bust (like tech stocks), so does your mutual fund. They have some diversity to balance out, so they’re better than buying regular stocks in those companies, but they fluctuate in a slightly more extreme way than the market and can render heavy losses.
By definition, an index fund will mirror the performance of whatever index it tracks, less expenses. If you care little about “beating the market” and are happy with matching market average returns, then an index fund will do that for you.
Some are narrow, like Dow index funds. Others are broader like S&P 500 index funds. There are even funds that index to a very broad selection of thousands of individual stocks. There’s probably a fund somewhere for any market index that you care about.
You can check out many of these at Vanguard.
In general “mutual” funds do much WORSE than the “market.” Not only are their managers with big salaries that take their cut, they tend to trade too much and actually underperform the index that best matches their investment approach. However, as pointed out above, if you want to invest in the “market” you can simply buy what is referred to as an exchange traded fund or ETF. There is an ETF for the SP-500, symbol SPY, one for the Dow Jones industrials, symbol DIA, one for the 100 of the biggest companies in the Nasdaq, symbol QQQ, and many others. For social security investment purposes, the best measure of the market would be the SP-500. You can buy the SPY in any brokerage account and buy/sell all day as many times as you want, or there are mutual funds, Vanguard being the most widely known, that offer basically the same thing.
Hope this helps.
Common thinking among financial scholars and writers holds that the past performance is not a reliable predictor of future results. Over the years, numerous studies conducted on the subject have yielded ambiguous conclusions. As a result of this, the use of past performance as a predictor has not received the credibility and usage it deserves, and many analysts have turned to other factors as perceived reliable guides to future alpha (high) returns. Based on selection research this application concludes that once a large database has been reduced in size, enriched using past performance in conjunction with a benchmark, it is then possible to introduce any other factors without the quality of choice suffering. This application further proves that without using a Investment Selection Paradigm considering other factors before past performance analysis results in choices that produce mediocre to poor performance. The Investment Selection Paradigm succeeds by eliminating thousands funds that under perform the benchmark greatly enhances the performance quality of fund selection.
The keys to this application is the development of the Expected Total Return (ETR) and the Investment Selection Paradigm (ISP) based on the use of past performance data. This enables the separation of “superior†performing funds that out perform the selected benchmark from “mediocre to poor“ performing funds that under perform the benchmark. This method is superior to current selection methods that do not use past performance but use costs, expenses, loads, manager, anecdotal… information as selection factors.
To prove the worth of this application, a test of our method against a traditional fund selection method was conducted. We chose randomly from a 10,000 fund population of which 80% do not beat the S&P 500 but 20 do. Using the ETR and the ISP , we discarded 8,000 mediocre to poor performing funds leaving 2,000 superior performing funds relative to the benchmark . We then chose randomly from the superior fund group and compared the performance of this group with the larger mediocre group. It became clear the investor has great difficulty in choosing enough superior funds is that the mediocre fund group. This is because the mediocre represents 4 times the number of superior funds which are evenly distributed over the entire fund population. To imitate traditional practices of selecting funds, a random number generator chose 360 funds made up of 30 funds in each of 12 time intervals for periods of 12, 24, & 36 months from an open-ended fund population of 82,000. The tests were based on a prospective $10,000 investment. The Value Line Survey Mutual Fund Survey for Windows was used as a past performance data source and Market Watch was used as a net asset value source for pricing.
To apply our method of analyzing to past performance 360 funds made up of 30 in each of 12 time intervals were objectively selected benchmark using ETR and ISP computations and $10,000 prospectively invested in them. They were chosen, prospectively, from a 41,000 U.S. open-ended, fund population, and the data and net value for these funds were collected from the same sources.
The study results show that funds selected with the ISP method performed an average of 259% better than the benchmark, while funds chosen at random were consistently below at 90% of the benchmark, or an ISP advantage of 2.9 to 1.0.
Purchase Date Holding Period % cumulative total returns
S&P 500 Traditional
Method ISP
Method
Oct. 31, 2004 12 mos. 6.0 4.5 23.5
Oct. 31, 2003 24 mos. 14.5 8.5 45.5
Oct. 31, 2002 36 mos. 36.0 25.5 70.5
Pearson Correlation Coefficient 0.99 0.96
Nov. 30, 2004 12 mos. 6.2 7.5 23.2
Nov. 30, 2003 24 mos. 17.8 17.4 34.7
Nov. 30, 2002 36 mos. 33.0 25.5 58.0
Pearson Correlation Coefficient 0.98 0.99
Dec. 30, 2004 12 mos. 2.8 5.5 10.6
Dec. 30, 2003 24 mos. 12.2 11.5 22.2
Dec. 30, 2002 36 mos. 41.7 40.7 78.8
Pearson Correlation Coefficient 0.99 0.98
Jan. 31, 2004 12 mos. 8.3 9.4 29.1
Jan. 31, 2003 24 mos. 12.8 9.9 23.7
Jan. 31, 2002 36 mos. 53.2 41.9 98.7
Pearson Correlation Coefficient 0.99 0.98
Performance Relative to S&P 500 1 .00 0.90 2 .59