Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses

We use a new database to perform a comprehensive analysis of the mutual fund industry. We find that funds hold stocks that outperform the market by 1.3 percent per year, but their net returns underperform by one percent. Of the 2.3 percent difference between these results, 0.7 percent is due to the underperformance of nonstock holdings, whereas 1.6 percent is due to expenses and transactions costs. Thus, funds pick stocks well enough to cover their costs. Also, high-turnover funds beat the Vanguard Index 500 fund on a net return basis. Our evidence supports the value of active mutual fund management. DO MUTUAL FUND MANAGERS WHO actively trade stocks add value? Academics have debated this issue since the seminal paper of Jensen ~1968!. Although some controversy still exists, the majority of studies now conclude that actively managed funds ~e.g., the Fidelity Magellan fund!, on average, underperform their passively managed counterparts ~e.g., the Vanguard Index 500 fund!.1 For example, Gruber ~1996! finds that the average mutual fund underperforms passive market indexes by about 65 basis points per year from * Robert H. Smith School of Business at the University of Maryland and Graduate School of Business Administration, University of Colorado at Boulder. I gratefully acknowledge research support from the Richard M. Burridge Center for Securities Analysis and Valuation at the University of Colorado as well as support from the Institute for Quantitative Research in Finance ~the “Q-Group”!. I also gratefully acknowledge grants from the Graduate School of the University of Colorado and from the UCLA Academic Senate, which were used to purchase some of the data used in this study. My thanks to Franklin Allen ~the referee and AFA 2000 Program chairman!, Peter Bernstein, Doug Breeden, Stephen Brown, Jennifer Conrad, Bob Conroy, Ken Eades, Mark Grinblatt, Spencer Martin, John Pringle, Brian Reid, Sheridan Titman, Charles Trzcinka, and Steve Vincent for helpful comments on this paper. I also thank participants at the 2000 American Finance Association session ~in Boston, Massachusetts! on Mutual Fund Performance ~especially Tobias Moskowitz, the discussant! as well as participants at finance workshops at the University of Colorado, the University of North Carolina, the University of Texas at Dallas, and the University of Virginia ~Darden!. Excellent research assistance was provided by Bill Ding, Michael Oswald, Inchul Suh, and Jing Yang at the University of Colorado. Interestingly, the two largest funds in the United States, as of November 30, 1999, are the actively managed Fidelity Magellan Fund and the passively managed Vanguard Index 500 fund. Each fund manages roughly $97 billion. See www.investorhome.com0magic0 for updates on the relative fortunes of these two bellwether funds. Also of interest is the introduction of index funds by Fidelity and actively managed funds by Vanguard. THE JOURNAL OF FINANCE • VOL. LV, NO. 4 • AUGUST 2000