Monday, December 2, 2002
by Gordon Pape and Eric Kirzner
Viking Canada, 2002
The dilemma facing everyone who proposes to give advice on mutual funds is this:does past performance predict future performance? In other words, is there anything worth saying or even investigating about how a fund has performed? If not, then advice is pointless and all that can know about an investment portfolio is a its fee structure and mandate.
Gordon Pape wades into this morass with courage and a fine track record for turning out useful guides. Along with Eric Kirzner, a professor of finance at the University of Toronto, Mr. Pape provides insights into what may be future performance. His work is honest, accurate on past performance, and a sincere attempt to divine the future.
The case against studying the past performance of mutual funds as a guide to the future can be compared to going to a casino not to make bests oneself, but to bet on other perhaps wiser bettors. Now if the outcome of the games is zero sum and the games are fair (neither of which is exactly true, for if it were, the casinos would go bankrupt), there should be a normal distribution of winners and losers. In mutual funds, fees are the equivalent of the casino's edge. So the game is not zero sum. If a player stays at a table or a slot machine a for a very long time, the house is sure to beat him. Luck can't win against the house edge.
Investment returns are not even normally distributed. They tend to have fat tails, with bigger flops and bigger successes than normal distributions would predict. That may be the result of mod psychology as investors panic when prices plunge and hop on the bandwagon when they rise.
Seemingly talented players who attract a lot of side bets from novice players change. Fund mandates or the game rules, if you like, also change. Can you make a rational bet in this casino? In spite of Messrs. Pape and Kirzner's earnestness, you probably can't.
Still, there's a question of alternatives. Staying in cash is a losing strategy. Bank accounts and GICs scrooge their holders into penury these days. Making a success of direct stock investment requires more analytical power than most investors can muster. So making some equity investments or even bond investments through a mutual fund or an investment pool can be sensible. Few equity funds beat indexes over time, since indexes are fully invested and funds hold cash. Not all indexes can be replicated or are investable - this is a problem in emerging markets. Some indexes are barely more than one company - Nokia is most of the Finnish stock index, for example. But with persistence and some research and some luck, there should be a return to intellect. The authors argue that it is worth searching for managers blessed with the touch for making money. The truth is, there are no managers that beat their peers and benchmarks for all periods. To some extent, every mutual fund buyer is a Don Quixote in pursuit of the improbable.
The oldest and perhaps the most respected of Canadian fund manuals, Gordon Pape's Guide to Mutual Funds is thorough and wise. For the investor who wants management and the hand holding that managers and advisors provide, there is still no better guide than Gordon Pape's 2003 Buyer's Guide to Mutual Funds.