Why Dynamic’s Success Proves Nothing

In last weekend’s Financial Post, Jonathan Chevreau wrote an admiring piece about Dynamic Funds, one of the oldest fund families in Canada. The article profiled seven funds with 10-year track records of outperformance that “leave index-hugging rivals behind.”

“Many financial columnists, including yours truly, have imbibed the Kool-Aid of passive indexing and exchange-traded funds (ETFs),” Chevreau writes. “Many popular books refute the idea actively managed mutual funds can beat the indexes and recoup their fees.” He then goes on to say he was “shocked” that these seven funds managed to do just that, even though two of them have MERs over 4%.

First of all, acknowledging the power of index investing is not “imbibing the Kool-Aid,” which implies blind acceptance of an unproven claim. The futility of active management as a whole is not an opinion, it’s simple math. As this classic paper by Nobel laureate William Sharpe explained 20 years ago, “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

They key phrase here is “average actively managed dollar.” No sensible person would ever “refute the idea actively managed mutual funds can beat the indexes,” as Chevreau argues. Of course mutual funds can beat the indexes. Every year many of them do, and some have outperformed for 10 years or more, including the Dynamic funds profiled in the FP article. There is nothing shocking about this. The question is, how can an investor identify in advance which ones will outperform? Unless we can do that, past performance is as useful as last week’s football scores.

Chevreau suggests that Dynamic’s excellent track record is a useful basis for investors who are looking to beat the market going forward. I don’t think it is. I’m not disparaging Dynamic’s managers, and I’m not prepared to write them off as dart-throwers who simply got lucky. These managers are undoubtedly skilled and they made some great calls. However, 10 years ago, investors could not possibly have known that these funds would have been winners. Here’s why:

  • Have a look at the list of funds available from Dynamic. It’s enormous — even excluding the US-dollar versions and the hedge funds, I counted close to 100. Why should we be surprised to see seven funds with excellent track records in a family this large? Perhaps Dynamic would be willing to publish the 10-year performance of all of their funds so investors can see what percentage of them outperformed.
  • Of the seven funds named in the article, only two have the same managers today (Chuk Wong and Noah Blackstein) that they did 10 years ago. If you chose any of these funds a decade ago because you admired the manager, you should logically have sold it when the manager departed. By the same token, if you choose a fund today based on the track record of its current manager, you have no assurance he or she will still be managing the fund in five or 10 years.
  • In some cases, if you look at these funds’ performance over a different period, they stop looking so good. The Dynamic American Value Fund beat its benchmark over the last 10 years, but not over the last 20, according to Globefund, so how would it have looked to an investor in 2000? The Dynamic Dividend Fund has also lagged over 15- and 20-year periods, and over the last five years, too. How does an investor know what the next 10 years will bring when outperformance comes and goes?
  • Survivorship bias makes every fund family’s performance look better than it really is. Chevreau dismisses this by saying “but all Dynamic’s winners have at least 10-year records.” That’s completely missing the point. Of course the survivors have 10-year track records—that’s what makes them survivors. What investors need to know is how many other Dynamic funds have been folded or merged because they have not performed well. And how many have changed their mandate over the last 10 years because the original strategy wasn’t working out?
  • It’s questionable whether these funds are even being compared to appropriate benchmarks. Many Dynamic funds have such vague mandates that it’s impossible to measure them against any index. Both the Dynamic Value Fund of Canada and the Dynamic Dividend Fund, for example, are measured against the S&P/TSX Composite, but both have about 30% of their holdings in foreign stocks.

I’m happy to join Chevreau in tipping my hat to the Dynamic managers who performed so well over the last 10 years. But until someone is able identify who we’ll be doffing our caps to in 2020, active management remains a shell game that most investors will lose.

19 Responses to Why Dynamic’s Success Proves Nothing

  1. Roger Wohlner December 14, 2010 at 8:42 am #

    Good post. With each passing year I am more and more convinced that passive index investing (both mutual funds and ETFs) is a solid core for most investors. Active management has its place, but much analysis is needed. Further an analysis of why certain active funds did outperform and what that might or might not imply for future performance. While some fund families do have certain investment processes in place, you need to look at the individual management of an active fund and fully understand the fund’s investment process. Very tough for most folks.

  2. Value Indexer December 14, 2010 at 9:06 am #

    I read that too – good to see there are other bloggers ready to do the background research to validate it :) One of the important things the article didn’t mention was whether the fund managers also invest most of their own assets in the fund. If that’s the case at least they feel losses to. If not I would be looking for increasing risks in the future until something goes the wrong way.

  3. Canadian Capitalist December 14, 2010 at 12:12 pm #

    Great post! I have another bone to pick with Jon’s article. He calls the outperformance “consistent”. Actually, it’s all over the map. The one fund I looked at Dynamic Dividend, beat the market in 5 out of 10 years and trailed the market 5 out of 10. That’s not “consistent” in my book because if you wait another year, the outperformance could just as easily turn to underperformance.

  4. Roger Wohlner December 14, 2010 at 12:17 pm #

    @Canadian Capitalist Playing devil’s advocate to your comment, does annual performance or longer-term performance matter more? For example would a fund that out performed for the trailing 5 and 10 year cycles outweigh the fact that it may have only outperformed its benchmark in 5 of the 10 years? (hypothetical question)

  5. Think Dividends December 14, 2010 at 3:17 pm #

    BOTTOM LINE: Passive Index Investing is only as good as the Index you are trying to copy.

    I would NOT want to blindly follow the TSX (3 sectors = 78% of the index) or the Switzerland Index (3 stocks = 45% of the index). On the other hand, I don’t mind passively following the S&P 500.

  6. Canadian Couch Potato December 14, 2010 at 3:31 pm #

    @Think Dividends: No argument here. An index fund that tracks the TSX is fine as one component of a portfolio, but it should be balanced with international stocks that provide access to sectors that are underrepresented in our market.

  7. Value Indexer December 14, 2010 at 4:10 pm #

    @Roger: I would say performance doesn’t tell you anything. Yes you would want an active manager to outperform long-term, but you should also be ready for them to underperform half the time along the way.

    Based on that you would want to see evidence of some past performance, but you would also want to see if the manager appears to be reasonable, independent, transparent, and sharing in the pain if they lose money. If you read a few reports you might start to get an idea of whether you’re reading another Buffet or another “Dow 36000″ guy.

    Another important point is that some (if not all) of these funds have not had the same manager over the full 10 years. In other words you can’t attribute even their good numbers to one person who might just stick around for another 20 years to keep doing the same.

  8. Orbison December 14, 2010 at 4:25 pm #

    If history is any guide, and we all know that it normally is not, then in 10 years the following could very well happen:

    2 out of the 7 will be merged out of existence
    3 out of 7 will significantly underperform the assigned benchmark
    1 out of 7 will peform in line
    The other will significantly outperform and someone will write an article on how that is proof that active management is superior to low cost indexing strategies.

    Someone should now follow all of these 7 as an experiment.

  9. Roger Wohlner December 14, 2010 at 4:29 pm #

    @Value Indexer I was trying to be a bit generic with comment as I am not at all familiar with the funds in the article. Your last point is the most key when looking at an active manager. I am an advisor here in the US and do use some active funds along with passive index funds and ETFs. It is critical in looking at the track record of an active manager to know how long the current manager(s) have been in place. If a fund has a solid long-term track record under the same management using the same investment process and they are just going through a couple of bad years I would tend to be a bit more patient with this fund vs. a fund with a brand new manager.

  10. Canadian Capitalist December 14, 2010 at 4:34 pm #

    @Roger: If I were an active investor, I should prize beating the benchmarks over the long term more than whether it is done on an annual basis. But human nature being what it is, a few years of under performance means the investor will likely start looking for greener pastures. Is it any wonder then that the fund companies like to advertise “five star” funds?

  11. Jambo411 December 14, 2010 at 6:44 pm #

    Pass the Kool-Aid. With MER’s like these I would have dumped a fund the first year it underperformed and missed the years it outperformed.

  12. Value Indexer December 15, 2010 at 10:23 am #

    To echo what CC said it’s the long-term performance that counts – but I would prefer to invest after a couple of underperforming years when everyone has left :) It certainly holds better prospects than investing after gathering a collection of awards and glowing articles. I’m not familiar with the funds at all before this article; it almost gives the impression that every fund the company runs is outperforming when it’s only a small number :)

  13. Financial Cents December 15, 2010 at 2:12 pm #

    MERs over 4%? Wow. I thought paying 2% plus was bad. I can’t believe some folks pay this. You’d hope you’d beat the index the fund tracks if you’re paying $400 per year for every $10 K invested.

  14. Value Indexer December 15, 2010 at 5:12 pm #

    Interestingly these funds seem to have performance fees too – I don’t know if “2 and 20″ is still the standard for good hedge funds but at least that’s lower than a 4% fixed fee plus a performance fee.

  15. Andrew Hallam December 15, 2010 at 10:53 pm #

    Dan,

    This is a fabulous post. Congrats!

  16. Brian December 16, 2010 at 12:20 pm #

    This post seems to be getting alot of attention =)

    I’d be interested to see what returns the average investor made in these funds. I’m almost certain that the those piling into this fund now will regret it.

  17. Roger Wohlner December 16, 2010 at 12:27 pm #

    @Brian Here in the states Morningstar does a calculation of the fund’s returns and those if the average investor. Sometimes the differences are quite striking. As an advisor to 401(k) plans mantra “…money chases performance…” is really apparent among some retirement plan participants. To me investors need a strategy and they need to both follow it and tweak from time to time. Set it an forget it and/or following the hot trend (blindly) is a formula for disaster.

  18. Value Indexer December 16, 2010 at 1:13 pm #

    When my wife joined her pension plan she was handed a sheet that listed the names and performance for a variety of funds and nothing else (a bit more information came later with the registration forms but it’s clear what was put in front of everyone first). If that’s common in companies offering 401(k)s the results won’t be surprising when participants choose between 3 international equity funds. I wonder what would happen if new participants were given only a list of fund names and the annual expenses for each one… I’m guessing that will never happen though :)

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