| Sargent & Lundy Savings Investment Plan |
| MUTUAL FUNDS: WHAT MAKES A WINNER? |
| The following excerpts are from an
article in the February 1998 newsletter, "401(k)
Advisor". The opinions expressed by the author,
Jerry Bramlett, may or may not reflect those of the SIP
Committee. The popular press has announced the result of the mutual fund 1997 grand prix. Winners and losers are determined by total return over the past year. managers who end up at the top of their classes are the winners. Lists of the top 10 funds, the top 50 funds, and the top 100 funds dazzle us. After the dazzling, then what? For mutual fund historians, the results may be of interest. But for most of us, this race garners out attention because we are interest in the future. Here's the rub: mutual fund total returns are worse than useless in predicting future performance. It's "worse than useless," because the funds at the very top have a higher than average probability of descending to the basement. Two things are often at work: lucky speculation and a promotion binge. The binge results in a rapid increase in assets, and the high volume of cash flows and larger asset base create challenges for managers. because these challenges are often new, not all managers rise to the occasion. For some funds, however, total returns are merely useless. The reason? Manager talent is responsible for only a portion of a fund's total return. In addition to a manager's skill, other contributors to total return are end point sensitivity, market risk, asset class, expenses and turnover, and luck. End point sensitivity. Because risky assets are volatile, peer ranking can be very sensitive to the end point used for comparison. Two factors influence good performance: great performance by the end of the period and lousy performance just prior to the start. Sometimes one lucky quarter or year makes a manager look talented; but absent that lucky period, the fund falls from the top to bottom quartile. Evaluations should include many end points besides the most current. Risk. Risk and reward are positively related. Not all risk increases return, because the market does not reward risk that can be avoided. Only risk that cannot be avoided is eventually rewarded. A fund's return, then, is directly related to the risk that fund takes. A manager with a winning total return who took even greater risk has subtracted value: All risk collects its due. Asset class. Asset classes are broad groups of similar securities that tend to rise and fall together. Academic research has convincingly demonstrated that asset class determines over 90 percent of a fund's performance. Nevertheless, because of the magic of compounding, the manager's 10 percent of value translates into a substantial difference in wealth. Expenses and turnover. Expenses obviously subtract from performance. They can be justified only by the value a manager adds after expenses are taken into account. Turnover also represents an expense that is hidden, because a fund's expense ratio does not include brokerage commissions and execution costs. Luck. Luck is an omnipresent reality that makes manager evaluation difficult. The average return of "luck" across managers and over time is zero: No one is lucky all the time. The less diversified a portfolio, the more luck plays a role in outcome. Talent. Talent is the value a manager adds. Managers add value by their decisions on what to buy, what to sell, and the timing of those decisions. Evaluations of manager ability are predictive of future success, but total return is not enough to evaluate the manager's part. That's why these other factors must be screened out before evaluation begins. |
This page updated on 3/16/98