A Reader Question about Choosing Winning Mutual Funds

A long-time reader who prefers to remain anonymous asked an interesting question about a strategy to pick winning actively-managed mutual funds. Here is an edited version of his question:

I'd love to hear your input on a friendly discussion with a good friend on active mutual funds versus passive indexing. I fall on the indexing side of the debate but I'm having trouble finding flaws with the approach he's been using.

He looks for 5-star active funds with "low-risk, high-return" characteristics as dictated by Morningstar and/or Scotia Research, then selects funds that have performed better than the group average over short and medium term (1 month to 3 years) under the same management. He will then hold these funds and review every 3-6 months or so, selling them if they no longer exceed the group average returns.

Whenever I pick a suitable index (regardless of asset class, though he favors Canadian and Global Small Cap), his funds have almost always done considerably better than the index, even after accounting for the high MER (often 3%+).

Other than the risk of that particular manager departing the fund right after he buys it, I'm having trouble identifying the downside.

Is it a viable approach or just luck so far?

There was a short period of time when I used to pore over mutual fund listings trying to puzzle out which funds would outperform in the future. However, the studies I’ve read all agree that this is futile because good performance does not persist into the future.

It isn’t possible for such studies to try every possible way to choose funds. You could focus on any one of several different time-periods for returns (1 month, 3 months, 6 months, 1 year, 3 years, 5 years, or 10 years). You can vary how often you make changes, and you can add in other criteria such as the reader’s friend did with manager persistence. So, there is no study that specifically looks at the exact strategy described above.

When someone looks at past data and tries out different strategies, this is called data mining. Even if 90% of funds fail to match their benchmark index over 10 years, you can always use data mining to find a strategy that would have chosen mostly funds in the winning 10%. Even if the strategies are just random, eventually one of them will happen to choose past funds that outperformed.

Perhaps the reader’s friend didn’t do any data mining and just happens to have a strategy that has performed well recently. The problem we’re now faced with is that we can’t distinguish skill from luck. Maybe this new strategy will perform consistently well for the next 20 years. But more likely, it will perform randomly, and because most funds underperform, a random strategy is likely to underperform. If this turns out to be the case, then the 3% MERs will become quite painful.

In the end it’s impossible to tell if an active strategy is a winner or if the investor is simply lucky. But just going by the track record of supposedly winning strategies, I’m not optimistic about this one. A further problem is that even winning strategies don’t work forever. I can’t say for certain that the reader’s friend is simply lucky, but I won’t be betting any of my money on this strategy.