When an Active Mutual Fund Manager Beats the Market is it Luck?

For the second year in a row Bill Miller’s Legg Mason Value Trust mutual fund underperformed the S&P 500 Index (-6.7% return for the Value Trust vs. 5.49% for the S&P 500). These two years of underperformance come after a fifteen year run in which Value Trust outperformed the S&P 500. All this brings us to this question:

Were those 15 years of overperformance due to luck?

That’s the claim that Larry Swedroe makes in his latest newsletter.

For believers in active management the equivalent of finding the Holy Grail is identifying a manager who can persistently beat the market. The hero for many “believers” had been Bill Miller, legendary manager of the Legg Mason Value Trust (LMVTX). 2005 marked the fifteenth straight year his fund had beaten the S&P 500 Index—the longest streak on record. To the “faithful,” surely fifteen years had to be the result of skill and not random luck. That belief led to huge inflows of assets over the years. On the other hand, perhaps the streak was purely a lucky one. In 2006, the fund returned 5.9 percent, underperforming the S&P 500 Index by 9.9 percent. Perhaps that was just one bad year. Perhaps the market just did not see what Miller saw as real value. Unfortunately, the fund managed to repeat that dubious feat in 2007. The fund lost 6.7 percent, underperforming the S&P 500 Index by 12.2 percent. The last two years left the fund with a cumulative five-year record of underperforming the S&P 500 by 2 percent per annum.

Was Miller really skillful—and he had just lost his touch? Or, was he lucky and “Lady Luck” had abandoned him? And how is an investor to know which is the correct answer? And what should an investor in the fund do now? If you stay with the fund, how long do you wait before you give up? And if you sell, what if he turns the performance around—how would you know if it was skill or random luck showing up again?

The really bad news is that most of Miller’s great returns came when the fund was much smaller. The great returns attracted huge cash flows, and the longer the streak went on the greater the flows. The worst performance came when the fund had the most dollars. Thus, the returns actually earned by investors in the Legg Mason Value Trust are actually well below the returns reported by the fund. Of course, this is not the fault of the fund. Instead, the fault lies with investors who chose to ignore the evidence from academic studies that there is virtually no persistence of performance beyond the randomly expected (at least among winners—losers tend to repeat because of high expenses). And, as history suggests it would, the fund experienced large outflows in 2007. Investors withdraw almost $10 billion of assets in the fourth quarter of 2007 from the Legg Mason family of funds. Thus, even if Miller manages to once again outperform, many investors won’t be there to benefit.

Larry makes a good point. It is very difficult for a mutual fund to beat the benchmark. If they do, new money flows in which inevitably leads to underperformance. And, as the name implies Value Trust is a value fund. As this post shows, growth beat the snot out of value in 2007. That said, I do find it hard to believe that 15 years of beating the benchmark can be chalked up to luck.

What do you think?

Larry’s Disclaimer:

Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide to a Winning Investment Strategy You’ll Ever Need (2005), What Wall Street Doesn’t Want You to Know (2000), Rational Investing in Irrational Times – How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003), and co-author of The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006) (All Affiliate Links). He is also a Principal and Director of both Research of Buckingham Asset Management and BAM Advisor Services — a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices — in Clayton, Missouri (www.bamservices.com).

His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.

7 thoughts on “When an Active Mutual Fund Manager Beats the Market is it Luck?”

  1. Value has higher expected returns than growth, so a Large Value fund maybe has a 60% chance of beating the S&P 500. Then the chances of 15 years in a row are 1 in 2500.

    Is that unlikely? Well, Bill Miller was the only one to do it. There are probably over 2000 managers, so the probability of having at least one person do it in 15 years are over 50%.

  2. 15 years of luck seems unlikely. I would attribute the good performance to skill and the performance decline to the difficulty in managing more and more money. That is a common problem for ‘hot’ funds that grow quickly.

  3. First, why does it have to be all one or the other? Maybe the manager had above average skill that contributed to his past success. Maybe he also was a bit lucky.
    I think that it is not possible to draw conclusions regarding the performance of a specific fund manager. However, I think it can be said that the total distribution of fund performances is not significantly different from a distribution of performances based on chance. In a chance distribution one would still expect some exceoptional fund performances.

  4. Andy makes a good point. And let us not forget about all of the mutual funds that started and petered out over the last 15 years. One might even ask why there weren’t more managers like Miller.

    It is difficult for me to call something skill when it happens with the same frequency that random chance allows for, especially when there is no basis for such skill to even exist.

    If a stadium full of people tried to guess the outcome of 15 coin tosses in a row, there would be a scattered group of random individuals who were correct 15 times. If you were to ask them how they did it, you might even get a believable sounding description of their coin-flip-calling methodologies, but there is no basis for this skill either.

  5. 15 years seems like an awful long time for luck. However, I don’t think that a person, or even a passive investor will meet or perform better than the market very year. William Bernstein makes the point in his book that there will be periods of time when even an index investor will not beat the market due to certain factors.

    2 years is a short-term timeframe to judge Miller’s performance.

    The Dividend Guy

  6. Div Guy – Assuming minimal tracking error an index investor will never beat the market and will always match it less expenses. This is not a bad thing because the index investor will still fair better than the average investor because of lower costs.

    Every time someone wins the lottery, they overcome odds far greater than beating the market for 15 years and that is all luck. The strange thing about probability is that it often runs counter to what feels right.

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