Unveiling the Key to Mutual Fund Outperformance, and it has Nothing to do with Fees!

It’s become almost common knowledge these days that the key to building a portfolio of outperforming mutual funds or ETFs is to simply pick the lowest cost option available in the categories to which the investor wants exposure. In this article we’ll offer a slightly different take, that the real key to finding outperforming mutual funds and thus building an outperforming portfolio of funds, is to find funds with a track record of superior risk management that allow them mitigate the impact of deep losses in the stock market. We’ll call these funds Drawdown Champions. Our findings are based on the analysis of the performance of 443 mutual funds spanning three of the largest fund categories and point to a much higher than average probability of long-term outperformance by Drawdown Champions than all other funds. Moreover, Drawdown Champions tend to have average to above average fees and average to below average assets under management (AUM), suggesting that low fee, high AUM genre of investment products may not be optimal for the end investor.

Method:

In this study we reviewed trailing four-year nominal and risk-adjusted performance of every Diversified Emerging Market, World Stock, and US Large Blend mutual fund with a track record dating back to the cyclical peak of the category benchmark in 2011. Only I and Y share classes were included in the study so as to capture the share classes with the lowest fees and only one share class per fund was used (the lowest fee class) if the fund had both I and Y shares. Funds which were in the top decile of category performance during periods of deep market drawdowns during both of the two identifiable stock market corrections since 2008 (defined as a S&P 500 peak to trough decline of at least 10%) were defined as Drawdown Champions. The two market corrections used in this study were thus the correction that occurred in the Fall of 2011 and the one taking place currently. The median nominal and risk adjusted performance of Drawdown Champions was then compared to all other funds in each respective category.

Results:

Diversified Emerging Market Mutual Funds

The benchmark for Diversified EM mutual funds is the MSCI EM total return index. Of the 91 Diversified EM mutual funds 5 funds can be categorized Drawdown Champions, a fund that performed in the top decile relative to their category peers in both the 2011 and 2015 corrections. Over the last four years the Drawdown Champions outperformed all other funds in the category by 2.3% annually on a nominal basis and had .33 more units of annual return per unit of annual risk. 80% of Drawdown Champions outperformed the benchmark on a nominal basis and 80% outperformed on a risk adjusted basis. These numbers compare favorably to all other funds, of which only 57% outperformed on a nominal basis and only 57% outperformed on a risk-adjusted basis. Drawdown Champions had an 11 bps higher fee than the other funds and a $112 million higher AUM on average. Results displayed below.

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World Stock Mutual Funds

The benchmark for World Stock mutual funds is the MSCI World total return index. Of the 134 World Stock  mutual funds 2 funds can be categorized Drawdown Champions, a fund that performed in the top decile relative to their category peers in both the 2011 and 2015 corrections. Over the last four years the Drawdown Champions outperformed all other funds in the category by 1.0% annually on a nominal basis and had .68 more units of annual return per unit of annual risk. 50% of Drawdown Champions outperformed the benchmark on a nominal basis and 100% outperformed on a risk adjusted basis. These numbers compare favorably to all other funds, of which only 36% outperformed on a nominal basis and only 30% outperformed on a risk-adjusted basis. Drawdown Champions had an 2 bps lower fee than the other funds and a $195 million higher AUM on average. Results displayed below.

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US Large Blend Mutual Funds

The benchmark for US Large Blend mutual funds is the S&P 500 total return index. Of the 218 US Large Blend mutual funds 2 funds can be categorized Drawdown Champions, a fund that performed in the top decile relative to their category peers in both the 2011 and 2015 corrections. Over the last four years the Drawdown Champions outperformed all other funds in the category by .80% annually on a nominal basis and had .29 more units of annual return per unit of annual risk. 100% of Drawdown Champions outperformed the benchmark on a nominal basis and 100% outperformed on a risk adjusted basis. These numbers compare favorably to all other funds, of which only 59% outperformed on a nominal basis and only 42% outperformed on a risk-adjusted basis. Drawdown Champions had an 4 bps higher fee than the other funds and a $1.3 billion lower AUM on average. Results displayed below.

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Discussion:

There are a number of ways an equity fund manager can attempt to outperform their benchmark. The most common way would be to take more risk than the benchmark by raising the portfolio beta organically or employing the use of leverage. Avoiding large drawdowns and then buying stocks at the new, lower prices is another way. But the reality is that very few funds are able to outperform their benchmark on a nominal basis over a long period of time, and even fewer are able to do so on a risk adjusted basis. This study points to the elevated likelihood of outperformance by funds which have a demonstrated track record of applying risk management techniques to mitigate the capital destroying consequences of large market falls. The findings are consistent across three of the largest mutual fund categories and apply to both Drawdown Champions as a whole and at the individual fund level. The study also shows that Drawdown Champions do not have substantially different than average fees. These points together introduce the possibility that the “pick the lowest cost fund” meme may not be the optimal investment strategy. Instead, allocators of capital might achieve a higher aggregate hit rate of picking outperforming funds by focusing instead on funds’ demonstrated risk management capabilities.