Financial Education

A recent article at 24/7 Wall St. points to what the author describes as the Dumbest Column of the Year

As the end of the column makes clear, however, Middleton is not content to just trash one of the best-performing mutual funds of all time: He wants to condemn the whole indexing movement. To wit:

…over longer periods, indexes do not compare favorably with above-average mutual funds, and they are shamed by really good ones. Here are examples:

Middleton then lists four indices–the S&P 500, the S&P Mid-Cap, the S&P Small-cap, and the MSCI EAFE International–followed by the “average” fund for each asset class and a couple of funds that have beaten the indices. In every case, not surprisingly, the “average fund” lagged the appropriate index in most of the time periods shown. Also not surprisingly, the top performers beat the indices.

So where’s the stupidity? As usual, in the omissions.

First, because Middleton has demonstrated after the fact that some funds beat their benchmarks, he wants his readers to believe that such funds would have been easy to identify ahead of time. Again, half a century of academic research suggests otherwise.

Actually, recent research indicates that it is possible to identify outperforming funds in advance – or at least to bring the odds of doing so to nearly 60%, and a weighted average portfolio of the “best” managers under this selection process returned 3% (300 basis points) more per year than the benchmark return.

The research in question, The Right Answer to the Wrong Question: Identifying Superior Active Portfolio Management by Harlow and Brown, was published in the Journal of Investment Management, Fourth Quarter 2006.

For more information, see all articles on: Investment Returns, Research, Security Selection

See also:

Forecasting Fund Manager Alphas

Do Market Timing Hedge Funds Time the Market?

Due Diligence for Hedge Fund Managers

Research and Development Expense

Determinants of Funds of Hedge Funds Performance