Treynor&Mazuy-1966-CanMutualFundsOutguesstheMarket

JWPR040-11JWPR040-TreynorSeptember3,20076:57CharCount=0CHAPTER11CanMutualFundsOutguesstheMarket?AReportonthePerformanceof57FundsandtheirSensitivitytoMarketFluctuationsAremutualfundmanagerssuccessfullyanticipatingmajorturnsinthestockmar-ket?Thereisawidelyheldbeliefthattheyare.Whetherinvestmentmanagersthemselvesactuallysharethisbeliefishardtosay.Atonetimeoranotherinpromot-ingtheirservices,however,anumberofmutualfundshaveusedtheclaimthattheycananticipatemajorstockmarketmovements.Wehavedevisedastatisticaltestofmutualfunds’historicalsuccessinanticipat-ingmajorturnsinthestockmarket.Applyingthistesttotheperformancerecordof57open-endmutualfunds,wefindnoevidencetosupportthebeliefthatmutualfundmanagerscanoutguessthemarket.DEBATEDRESPONSIBILITIESThequestionwehavestudiedhasanimportantbearingontheresponsibilitiesthatinvestmentmanagerscanproperlybeaskedtoassume.Forinstance,todayalmosteveryoneagreesthatthemarketwasdangerouslyhighinearly1929andthatstockswereabargaininthe1950s.Onhindsight,laymenaretemptedtothinkthattheseextremesshouldhavebeen“obvious”tofundmanagersatthetime,andthattheyshouldhavesoldorboughtcommonstocksaccordingly.Inactuality,ofcourse,fundmanagersdidnotalwayssellin1929andbuyinthe1950s.Whatpositionshouldthefundmanagertaketoprotecthimselfagainstaccusa-tionsthatheshouldhaveanticipatedmarketmovementsinthisway?Morebroadly,whatdoestheshareholderhavearighttoexpectfromthefundmanager?Isthefundmanagerspeculatingifheattemptstoanticipatemajormarketmovements?Orishenegligentifhefailstotry?ItseemstousthattheanswerstothesequestionsdependReprintedbypermissionofHarvardBusinessReview.From“CanMutualFundsOutguesstheMarket?”byJackL.TreynorandKayK.Mazuy,Jan–Feb1966.Copyrightc1966bytheHarvardBusinessSchoolPublishingCorporation;allrightsreserved.CoauthoredwithKayK.Mazuy.88JWPR040-11JWPR040-TreynorSeptember3,20076:57CharCount=0CanMutualFundsOutguesstheMarket?89inpartonwhetherornotinvestmentmanagersactuallyhavetheabilitytoanticipatemajorturnsinthestockmarket.Becauseamutualfund’sperformanceineachsucceedingyearisreadilymeasured,widelypublished,andeasilycomparedwiththatofothermutualfunds,managersinthisindustryareperhapsparticularlysensitivetotheeffectontheirfunds’perfor-manceofamarketdeclineormarketriseduringtheyear.Webelievethatourfindingsmayhavesignificancenotonlyformutualfundmanagers,butalsoforpension,trust,andendowmentfundmanagers—despitethefactthattheirobjectivesvarywidely.Ifitisgenerallytruethatinvestmentmanagerscannotoutguessthemarket,thenitmaybenecessarytorevisecertainconceptionsabouttheresponsibilitiesofinvestmentmanagementacrosstheboard.ANALYTICALAPPROACHItiswellknownthatthereisadefinitetendencyforthepricesofmostcommonstockstomoveupanddowntogether.Becausethistendencyexists,itismeaningfultotalkaboutfluctuationsinthe“market.”Itisalsowellknownthatsomecommonstocksaremorevolatile(i.e.,sensitivetomarketfluctuations)thanothers.Thus,whenwetalkaboutinvestmentmanagersoutguessingthemarket,wemeananticipatingwhetherthegeneralstockmarketisgoingtoriseorfallandadjustingthecompositionoftheirportfoliosaccordingly.Thatis,iftheythinkthemarketisgoingtofall,theyshiftthecompositionoftheportfoliostheymanagefrommoretolessvolatilesecurities(includingbonds).Iftheythinkthemarketisgoingtorise,theyshiftintheoppositedirection.Theresultofsuchshiftsisachangeineffectiveportfoliovolatility.(AsimplegraphicalmeasureofportfoliovolatilitywasdevelopedbyoneoftheauthorsinapreviousHarvardBusinessReview(HBR)article,1andisreviewedinsomedetaillaterinthisarticle.)Inordertotestwhetherornotamutualfundmanagerhasactuallyoutguessedthemarket,weask,ineffect:Isthereevidencethatthevolatilityofthefundwashigherinyearswhenthemarketdidwellthaninyearswhenthemarketdidbadly?Thisisthequestionthatwasappliedtothe57fundswestudied.Ofcourse,wedidnotknowthatallofthemweretryingtooutguessthemarket,butthatdoesnotmatter.Unquestionably,someofthemweretryingtodothisandthoughttheyhadtheability.PerformanceDataUsedDataforthemutualfundsinoursamplewereobtainedfromInvestmentCompa-nies1963,byArthurWiesenbergerCompany.2Foropen-endinvestmentcompanies,Wiesenbergeremploysthefollowingformulatocomputerateofreturn:“Toassetvaluepershareattheendoftheperiod,adjustedtoreflectreinvestmentofallcapitalgainsdistributions,adddividendspersharepaidduringtheperiodfrominvestmentincome,similarlyadjusted;dividethetotalbythestartingpershareassetvalue.”3Theresultingrate-of-returnfigureisonlyapproximate,sinceitdisregardssub-tletiesrelatingto(1)thetimingwithintheperiodofdividenddistributionsand(2)therelativeafter-taxvaluetotheshareholderofmarketappreciation,ontheonehand,andofdividend-interestincome,ontheother.Wefeel,however,thatthemeasureisprobablyadequateforourpurpose,eventhoughtheseeffectsaredisregarded.JWPR040-11JWPR040-TreynorSeptember3,20076:57CharCount=090PERFORMANCEMEASUREMENTTheCharacteristicLineIf,yearbyyear,therateofreturnforamanagedfundisplottedagainsttherateofreturn,similarlydefined,forasuitablemarketaverage—suchastheDow-JonesIndustrialAverageortheStandard&Poor’s500-StockIndex—theresultisthekindofpatternsshowninExhibit11.1.Alinefitt