A while back, I was speaking with the manager of a mutual fund. In describing one of the stocks in his fund, he noted: “I owned it for a while, then I sold it, but then I bought it back.” It was a surprising comment since frequent trading is, in most cases, generally unproductive. Indeed, Warren Buffett has often said that his preferred holding period for an investment is “forever,” and many see that long-term mindset as one of the keys to his success.
At the same time, Buffett’s “forever” strategy hasn’t always worked out. He acknowledged making a mistake in owning IBM, which has seen its stock flatline for 10 years. Buffett’s Berkshire Hathaway also owned big positions in Wells Fargo and in Tesco before corporate malfeasance took both of these companies’ stocks down. In all three cases, Buffett chose not to hold on forever and did finally exit these stocks.
Buffett’s experience indicates that holding any investment indefinitely can pose problems. But on the other hand, there’s data showing that trading too frequently can also be detrimental. Brad Barber and Terrance Odean, for example, wrote a well known paper titled “Trading Is Hazardous to Your Wealth.”
As an individual investor, what should you conclude from these seemingly contradictory findings? In a recent set of studies, researchers at Morningstar looked at this question and offered useful perspectives.
In one study, Morningstar’s team looked at a group of 400 actively-managed mutual funds. They compared the funds’ performance over a 10-year period to an alternative scenario in which the funds’ holdings had been held static for those 10 years. They referred to these alternatives as the Do Nothing portfolios.
The result? Some funds would have done worse if their holdings had been frozen in time, while others would have done better. On average, though, the difference would have been negligible: The actual funds gained 12.1% per year over the 10 years ending March 31, 2023, while the Do Nothing alternatives would have gained 12.0% per year. The difference was almost immaterial—but that was before fees. Since actively-managed funds like this carry fees of nearly 1%, the net effect was that these funds’ managers detracted more from their funds’ performance than they contributed. As Morningstar put it, these fund managers would have been better off taking a vacation, “a long one.”
In another study, Morningstar examined “tactical asset allocation” funds. Unlike funds that pursue a single investment strategy, such as large-cap stocks, tactical funds have the latitude to switch among asset classes as their managers see fit. If they see a recession coming, for example, they might switch more of the funds’ assets into bonds. For these funds, Morningstar asked the same question: How would these funds have done if their holdings hadn’t changed at all over 10 years—in other words, if their managers had gone on vacation?
The result: Over the same 10-year period referenced above, tactical funds gained a modest 2.3%, on average, per year. But had the managers done nothing at all for 10 years, their funds would have gained twice as much. As Morningstar put it, “They came. They saw. They incinerated half their funds’ potential returns.”
I see two lessons in these results. First, when in doubt, be like Buffett. No doubt, you can make a mistake by hanging onto an investment too long, but on balance, it’s better to maintain a long-term mindset toward your investments. That means, of course, hanging on through the market’s usual ups and downs, and I’ll acknowledge that isn’t always easy. But as the tactical fund managers proved, the alternative can be much worse. It’s virtually impossible to make successful trades based on economic or market predictions. This risks “incinerating” returns. Instead, in my view, investors are better served choosing an asset allocation reasonable enough that they can live with it through the market’s ups and downs.
The second lesson we can learn from these studies: Fees really matter. The late Jack Bogle, founder of the Vanguard Group and an index fund pioneer, often said that he didn’t see active management as a problem per se; the problem was the high fees that most active managers charge. As Morningstar’s data found, the average large-cap manager actually outperformed the S&P 500—but that was before fees. And that is the fundamental reason why investors are, in my opinion, better off avoiding funds like this and instead opting for very low-cost funds, which usually means index funds.
What if an active fund manager has a solid long-term track record—should you still avoid it? Certain funds, whether it’s Fidelity’s Contrafund or Dodge & Cox’s Stock Fund, have enviable records and reputations to match. Maybe they’re the exception to the rule and worth a portion of your savings? It’s on this question that Morningstar’s new research is most helpful.
Look at the performance of the 10 largest domestic stock funds compared to their Do Nothing alternatives over the past decade, and you’ll see that the results are nearly evenly split. Six underperformed the Do Nothing alternatives. But the other four added value—even after fees in some cases. That might lead investors to conclude that it’s worth opting in to a few actively-managed funds. At first, that might seem logical. The challenge, though, is that fund performance isn’t static. Yes, some funds do have streaks of excellent performance, but no fund has exhibited permanent outperformance.
Standard & Poor’s tracks the mutual fund industry closely and can quantify this. In its most recent Persistence Scorecard, fewer than half of mutual funds that had above-average performance over one five-year period were able to maintain those above-average results in the following five-year period. Funds with really exceptional performance—in the top quartile—demonstrated even less of an ability to maintain that top-tier performance.
Why is it so hard for fund managers to do better than their indexes? It doesn’t seem very hard to spot up-and-coming winners like Google or Apple. As it turns out, it isn’t very hard. Fund managers actually do a great job picking stocks. The problem is on the other side of the transaction, and that’s what drives their underperformance.
In a 2021 paper titled “Selling Fast and Buying Slow,” researchers looked at the track records of professional fund investors and made this discovery: “While there is clear evidence of skill in buying, selling decisions underperform substantially.” In other words, investment managers can spot winners. But they don’t do a good job in choosing when to sell those stocks. Sometimes they sell too soon and miss out on future gains. Other times, they sell too late, after a stock has dropped. That’s why, according to the data, it’s best for investors to keep things simple, steering clear of actively-managed funds.
