According to the research paper “Scale and Skill in Active Management” by professors Robert Stambaugh and Luke Taylor, younger actively managed mutual funds outperform the older ones in a defined time frame. The path breaking study, published last year in the Journal of Financial Economics, also indicated that returns of funds decline as they grow older.
The professors cited an increase in the size of active management industry and the entry of new competitors as the main reasons behind their findings. Taylor said, “If there are more people fishing in the same pond, that’s going to make it harder for any individual person to catch a fish.”
Actively managed funds tend to invest in securities that are believed to be undervalued relative to their fundamentals and try to outperform broader indexes. In order to pursue this objective, asset management companies seek to employ active managers who utilize their forecasting power and judgement to decide on buying, selling or holding securities. As a result, portfolio compositions of these funds are believed to vary according to market conditions.
This makes the study an interesting reference when the performance of the younger funds is compared to the older ones. It will be interesting to see which category helps investors to achieve their objectives.
Younger versus Older Funds
Out of the mutual funds we studied, funds that were incepted on or after 2010 have been considered as younger funds and those incepted on or before 2005 have been categorized as the older ones. In order to analyze the performances of younger mutual funds compared to the older ones, we have selected the top 100 funds from each category on the basis of their performance since inception.
While the load adjusted average total return of 100 younger funds since their inceptions outpaced the same average of the top 100 older funds, the former also outperformed their older peers in recent years. Load adjusted average total return since inception of the top younger funds came in at 18% against 13.5% of the top older funds. Moreover, the younger category registered an average total return of 17.7% in the last three-year period compared to 16.4% gain witnessed by the older ones.
Last year too, when most of the mutual funds found it difficult to finish in the positive territory, the top younger funds managed to post an average gain of 4.4%, clearly outpacing the average return of only 2% registered by the top older ones.
Before concluding that the younger funds may prove to be more profitable than the older funds, as the facts indicate above, let’s have a look at some of the arguments given by professors Robert Stambaugh and Luke Taylor in their paper.
Arguments in Favor
Both Stambaugh and Taylor identified younger managers’ improving skills and ability to use advanced technology for forecasting as the main reasons for the outperformance of younger active funds. They argued that with gaining popularity of mutual funds over the years, level and quality of training has increased over time. Betterment of training helped new fund managers to gain exposure to higher education, advanced technology and research tools, which in turn had a positive impact on the performance. To quote Taylor, “New funds entering the industry have more skill … possibly because of better education or a better grasp on technology.”
Moreover, younger active funds that come with new strategies, never explored earlier, may attract more investor attention than the older funds. Separately, Taylor identified that the performance of a fund tends to decline with time as the industry size increases. With time, the number of competitors and size of individual funds are bound to grow.
With increasing size, trading volume of the funds also tend to rise, which weighs on a fund’s performance. In order to improve performance, the fund manager needs to increase exposure to undervalued stocks. This involves identifying stocks which are incorrectly priced relative to their intrinsic value and picking potential sellers of the same.
This will force the fund to offer a higher price for the stock if it is to be purchased immediately. Otherwise, the fund may wait for a longer period of time, which may result in the loss of some of the incentives of undervalued stocks.
4 Young Mutual Funds to Consider
Based on these facts, we present four mutual funds that were incepted in 2010 or later and carry either a Zacks Mutual Fund Rank #1 (Strong Buy) or #2 (Buy). We believe these funds will outperform their peers in the next few years.
Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify the potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but also on the likely future success of the fund.
Along with impressive returns since their inceptions, these funds also have encouraging one- and three-year total returns (as of December 31, 2015). The minimum initial investment is within $5000. These funds also have a low expense ratio and no sales load.
Fidelity Series Real Estate Equity seeks high income and capital appreciation. FREDX invests the majority of its assets in companies associated with the real estate industry across the world. FREDX is expected to provide a higher return than that of the S&P 500 Index. FREDX was incepted in October 20, 2011.
Since its inception, this Zacks Rank #1 (Strong Buy) fund has returned 12.7% and gained 3.6% and 12.7% over the past one- and three-year period, respectively. FREDX has an annual expense ratio of 0.74%, significantly lower than the category average of 1.29%. FREDX has no minimum initial investment.
MFS International New Discovery R5 (MIDLX - Free Report) invests in non-US equity securities, which also include equity securities of companies located in emerging nations. MIDLX invests in securities such as common stocks, preferred stocks and REITs. MIDLX invests in securities of companies that are believed to have impressive growth prospects. MIDLX may allocate a significant portion of its assets in a specific country or region. MIDLX was incepted in June 1, 2012.
Since its inception, this Zacks Rank #1 fund has returned 9.2% and gained 2.9% and 6.3% over the past one- and three-year period, respectively. MIDLX has an annual expense ratio of 0.95%, below the category average of 1.53%. MIDLX has no minimum initial investment.
Thornburg International Value R6 (TGIRX - Free Report) seeks growth of capital over the long run. TGIRX primarily focuses on acquiring securities of foreign companies and depository receipts. Though TGIRX invests in securities of companies located in both developed and developing nations, it invests a larger share of its assets in securities from developed markets compared to those from the developing markets. TGIRX was incepted in May 1, 2012.
Since its inception, this Zacks Rank #2 (Buy) fund has returned 9% and gained 6.8% and 5.4% over the past one- and three-year period, respectively. TGIRX has an annual expense ratio of 0.74%, lower than the category average of 1.34%. TGIRX has no minimum initial investment.
Strategic Advisers Growth (FSGFX - Free Report) generally invests in Fidelity Funds and non-affiliated funds that take part in Fidelity's FundsNetwork. FSGFX also invests in non-affiliated ETFs. FSGFX invests in large cap companies having market capitalization within the universe of the Russell 1000 Growth Index. FSGFX was incepted in June 2, 2010.
Since its inception, this Zacks Rank #2 fund has returned 16% and gained 5.1% and 16.7% over the past one- and three-year period, respectively. FSGFX has an annual expense ratio of 0.31%, below the category average of 1.18%. FSGFX has no minimum initial investment.
About Zacks Mutual Fund Rank
By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward. Pick the best mutual funds with the help of Zacks Rank.