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70%
1972“2001
60% Source: The
Vanguard Group.
50%

40%

30%

20%

10%

0
1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition




116 Part ONE Elements of Investments




F I G U R E 4.4 50
Growth of $1 invested
in Wilshire 5000
Index versus average Compound growth rate
40
(% / year)
general equity fund
Wilshire 5000 12.20
Source: The
Portfolio Value




Average Fund 11.11
Vanguard Group. 30



20



10



0
1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000
spreads that also reduce returns. John Bogle, former chairman of the Vanguard Group, has es-
timated that operating expenses reduce the return of typical managed portfolios by about 1%
and that transaction fees associated with trading reduce returns by an additional .7%. In con-
trast, the return to the Wilshire index is calculated as though investors can buy or sell the in-
dex with reinvested dividends without incurring any expenses.
These considerations suggest that a better benchmark for the performance of actively man-
aged funds is the performance of index funds, rather than the performance of the indexes
themselves. Vanguard™s Wilshire 5000 fund was established in 1992, and so has a relatively
short track record. However, because it is passively managed, its expense ratio is only about
0.20%; moreover because index funds need to engage in very little trading, its turnover rate is
about 3% per year, also extremely low. If we reduce the rate of return on the index by about
0.30%, we ought to obtain a good estimate of the rate of return achievable by a low-cost
indexed portfolio. This procedure reduces the average margin of superiority of the index
strategy over the average mutual fund from 1.09% to 0.79%, still suggesting that over the past
two decades, passively managed (indexed) equity funds would have outperformed the typical
actively managed fund.
This result may seem surprising to you. After all, it would not seem unreasonable to expect
that professional money managers should be able to outperform a very simple rule such as
“hold an indexed portfolio.” As it turns out, however, there may be good reasons to expect
such a result. We will explore them in detail in Chapter 8, where we discuss the efficient mar-
ket hypothesis.
Of course, one might argue that there are good managers and bad managers, and that the
good managers can, in fact, consistently outperform the index. To test this notion, we exam-
ine whether managers with good performance in one year are likely to repeat that performance
in a following year. In other words, is superior performance in any particular year due to luck,
and therefore random, or due to skill, and therefore consistent from year to year?
To answer this question, Goetzmann and Ibbotson3 examined the performance of a large
sample of equity mutual fund portfolios over the 1976“1985 period. Dividing the funds into

3
William N. Goetzmann and Roger G. Ibbotson, “Do Winners Repeat?” Journal of Portfolio Management (Winter
1994), pp. 9“18.
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition




117
4 Mutual Funds and Other Investment Companies


Successive Period Performance
TA B L E 4.4
Initial Period Performance Top Half Bottom Half
Consistency of
investment results
A. Goetzmann and Ibbotson study
Top half 62.0% 38.0%
Bottom half 36.6% 63.4%
B. Malkiel study, 1970s
Top half 65.1% 34.9%
Bottom half 35.5% 64.5%
C. Malkiel study, 1980s
Top half 51.7% 48.3%
Bottom half 47.5% 52.5%

Sources: Panel A: From “Do Winners Repeat?” by William N. Goetzmann and Roger G. Ibbotson, Journal of Portfolio Management, Winter
1994, pp. 9“18. Reprinted by permission of Institutional Investor. Panels B and C: From “Returns from Investing in Equity Mutual Funds
1971“1991,” by Burton G. Malkiel, Journal of Finance 50 (June 1995), pp. 549“572. Reprinted by permission of Blackwell Science, UK.

two groups based on total investment return for different subperiods, they posed the question:
“Do funds with investment returns in the top half of the sample in one two-year period con-
tinue to perform well in the subsequent two-year period?”
Panel A of Table 4.4 presents a summary of their results. The table shows the fraction of
“winners” (i.e., top-half performers) in the initial period that turn out to be winners or losers
in the following two-year period. If performance were purely random from one period to the
next, there would be entries of 50% in each cell of the table, as top- or bottom-half perform-
ers would be equally likely to perform in either the top or bottom half of the sample in the fol-
lowing period. On the other hand, if performance were due entirely to skill, with no
randomness, we would expect to see entries of 100% on the diagonals and entries of 0% on
the off-diagonals: Top-half performers would all remain in the top half while all bottom-half
performers similarly would all remain in the bottom half. In fact, the table shows that 62.0%
of initial top-half performers fall in the top half of the sample in the following period, while
63.4% of initial bottom-half performers fall in the bottom half in the following period. This
evidence is consistent with the notion that at least part of a fund™s performance is a function
of skill as opposed to luck, so that relative performance tends to persist from one period to
the next.4
On the other hand, this relationship does not seem stable across different sample periods.
Malkiel5 uses a larger sample, but a similar methodology (except that he uses one-year instead
of two-year investment returns) to examine performance consistency. He finds that while
initial-year performance predicts subsequent-year performance in the 1970s (see Table 4.4,
Panel B), the pattern of persistence in performance virtually disappears in the 1980s (Panel C).
To summarize, the evidence that performance is consistent from one period to the next is
suggestive, but it is inconclusive. In the 1970s, top-half funds in one year were twice as likely
in the following year to be in the top half rather as the bottom half of funds. In the 1980s, the
odds that a top-half fund would fall in the top half in the following year were essentially
equivalent to those of a coin flip.
Other studies suggest that bad performance is more likely to persist than good performance.
This makes some sense: It is easy to identify fund characteristics that will predictably lead to
consistently poor investment performance, notably high expense ratios, and high turnover

4
Another possibility is that performance consistency is due to variation in fee structure across funds. We return to this
possibility in Chapter 11.
5
Burton G. Malkiel, “Returns from Investing in Equity Mutual Funds 1971“1991,” Journal of Finance 50 (June
1995), pp. 549“72.
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition




118 Part ONE Elements of Investments


ratios with associated trading costs. It is far harder to identify the secrets of successful stock
picking. (If it were easy, we would all be rich!) Thus the consistency we do observe in fund
performance may be due in large part to the poor performers. This suggests that the real value
of past performance data is to avoid truly poor funds, even if identifying the future top per-
formers is still a daunting task.


>
4. Suppose you observe the investment performance of 400 portfolio managers and
Concept
rank them by investment returns during the year. Twenty percent of all managers
CHECK are truly skilled, and therefore always fall in the top half, but the others fall in the
top half purely because of good luck. What fraction of these top-half managers
would you expect to be top-half performers next year? Assume skilled managers
always are top-half performers.


4.8 INFORMATION ON MUTUAL FUNDS
The first place to find information on a mutual fund is in its prospectus. The Securities and Ex-
change Commission requires that the prospectus describe the fund™s investment objectives and
policies in a concise “Statement of Investment Objectives” as well as in lengthy discussions
of investment policies and risks. The fund™s investment adviser and its portfolio manager also
are described. The prospectus also presents the costs associated with purchasing shares in the
fund in a fee table. Sales charges such as front-end and back-end loads as well as annual op-
erating expenses such as management fees and 12b-1 fees are detailed in the fee table.
Despite this useful information, there is widespread agreement that until recently most
prospectuses were difficult to read and laden with legalese. In 1999, however, the SEC
required firms to prepare more easily understood prospectuses using less jargon, simpler sen-
tences, and more charts. The nearby box contains some illustrative changes from two prospec-
tuses that illustrate the scope of the problem the SEC was attempting to address. Still, even
with these improvements, there remains a question as to whether these plain-English prospec-
tuses contain the information an investor should know when selecting a fund. The answer, un-
fortunately, is that they still do not. The box also contains a discussion of the information one
should look for, as well as what tends to be missing, from the usual prospectus.
Funds provide information about themselves in two other sources. The Statement of Addi-
tional Information, also known as Part B of the prospectus, includes a list of the securities in
the portfolio at the end of the fiscal year, audited financial statements, and a list of the direc-
tors and officers of the fund. The fund™s annual report, which generally is issued semiannually,
also includes portfolio composition and financial statements, as well as a discussion of the fac-
tors that influenced fund performance over the last reporting period.
With more than 8,000 mutual funds to choose from, it can be difficult to find and select the
fund that is best suited for a particular need. Several publications now offer “encyclopedias”
of mutual fund information to help in the search process. Two prominent sources are Wiesen-
berger™s Investment Companies and Morningstar™s Mutual Fund Sourcebook. The Investment
Company Institute”the national association of mutual funds, closed-end funds, and unit in-
vestment trusts”publishes an annual Directory of Mutual Funds that includes information on

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