Be wary of performance figures | The Economist

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Golfers are familiar with the concept of a “mulligan” – the chance to get a shot back. Give an averagely talented player enough mulligans and he or she will get one close to the hole. And there is a version of the mulligan in asset management as well.

Readers will be familiar from previous blog posts with the idea that actively managed funds cannot be relied upon to beat the index. Many of these studies are conducted in the US market, which is probably the most effective (and therefore the most difficult to beat) in the world. But the same is true in Europe.

Figures from S&P Dow Jones Indices show that over the ten years to December 2017, less than 15% of euro-denominated European equity funds beat their benchmark; for emerging market currencies, it was less than 3%; and global currency, under 2%. For sterling-denominated currencies, less than a quarter of European and UK equity funds beat the index.

But I took a closer look at the UK market, because of some interesting details. The annual return of UK equity funds was 7.27%; The smallest S&P stock dividend yield was 6.48%. So how did the average fund beat the market when, the figures also show, most funds did not beat the market?

This is where the mulligan rule comes in. The performance results are ten years for money that has survived ten years. But most funds did not manage that; only 43% of UK equity funds in operation at the start of 2008 were still going at the end of 2017. Those that closed were, inevitably, not so good. If a fund lasts for ten years, it probably had a pretty good record. This is why managers can advertise funds with strong performance; if they have a bad asset, they can just close it and start over.

Ah, some investment advisors might say (in fact, this one tweeted me) that not all passive managers will outperform. But I looked at the Legal and General UK index tracker, which is one of the biggest, if not the cheapest. Its ten-year compounded return was 6.4% (it tracks the All-Share index, not the S&P). It will never be the best player in the category but customers can be sure that it is not the worst either.

So be careful about performance numbers. Another problem occurs with these funds that become stars (think Bill Miller at Legg Mason). They start small and then their good performance generates an inflow of investors. Sometimes, it’s harder to outperform a large asset than a small asset. But traditional performance figures look at the return of the fund, not the average investor. Say the fund had $20m in the first year, and returned 20%, creating inflows of $100m at the start of the second year. In the second year, the fund has $124m under management and earns 5%. The fund will have an average two-year return of 11.8%. But most investors will have earned only 5% because they only joined for the second year

Use a dollar-weighted yield and the average investor can be less than 2.5 percentage points behind the average fund; that’s what happened in the decade to the end of 2013, according to Morningstar. There’s a reason it’s easier to get rich investing other people’s money than it is to get rich investing your own.

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