The Secret to Predicting Mutual Fund Performance!

By Eric Burkholder

There is a very good article out today on MarketWatch.com.  "You are the best predictor of next bull or bear" The title is misleading but the theme of the article is this:  There is no evidence that any person or any expert has any ability to predict mutual fund returns or forecast the economy.  Actually, an even better summary of the article is in the affirmative: There IS significant evidence that traditional performance metrics cannot reliably predict mutual fund performance and there IS significant evidence that experts do a very poor job of predicting turning points in the economy.  

There is one metric that can predict mutual fund performance which I will get back to in a moment, but the things that cannot predict mutual fund performance, based on a 2004 study by the Financial Research Center titled "Predicting Mutual Fund Performance II: After The Bear," include:

• Past performance
• Morningstar ratings
• Turnover 
• Manager tenure
• Net sales
• Asset size
• Four risk-volatility measures
• Alpha 
• Beta
• Standard deviation
• Sharpe ratio

Yes, you read that correctly.  Not even the coveted 5-Star Morningstar Rating can reliable predict future performance.  But there is hope.  There is one measure that can reliably predict mutual fund performance and that is the expense ratio.  That is right.  Funds with low expense ratios “deliver above-average future performance across nearly all time periods.”

Does this make intuitive sense?  Not if you are in the "Active Management" camp.  If successful active management is probable then there should be a positive correlation between expense ratios and fund performance.  Think about it.  If I am the best stock picker in the market I will charge you more to benefit from my services.  If I am not so good then I will have to charge to less to entice you to pay me.  The only way lower expenses can correlate with better performance is if what you are paying for (Active Management) does not actually provide additional value.

The article also discusses economic forecasts and references Brandeis Prof. William Sherden who tested the accuracy of leading forecasters over decades. His research was published in “The Fortune Sellers: The Big Business of Buying and Selling Predictions.”  The conclusion he came to: “I see no way economic forecasting can improve since it is trying to do the impossible.”  He found that nothing could reliably predict the future direction of the economy and forecasts were no better than a random guess.  Read the article for more detail on 10 findings of the professor's research.

At the end, the article does not come right out and say it (they are in the business of selling active investing advice after all) but the conclusion should be that a globally diversified efficient portfolio based on asset allocation and your risk profile is your best opportunity at having long term investing success.

If you are a die hard market timer or stock picker you may still have reservations with the information in this article and have trouble accepting the growing pile of  academic evidence against you.  But we should all be able to agree on one thing:  There is substantial evidence that picking outperforming mutual funds or predicting the economy is nearly impossible.  If some one does have the ability to consistently do either of these they would have a very scarce and highly valuable skill.  So if you feel you are the exception to the rule or your financial advisor tells you that he/she is the exception to the rule then ask yourself these questions:

"Why is my financial advisor not a billionaire or charge me even more? He has one of the rarest skills on Earth."

or

"Why don't I quite my day job?  Hedge funds will pay me millions of dollars a year for this skill"

I think we all know the answer to these questions.  It may just take a little introspective thought and honest evaluation to bring them to the surface.