Coin Flipping Outdoes Active Fund Managers
Flipping a coin is a truly random event. A coin will land on either heads or tails, and guessing right is a 50-50 proposition. The performance of actively-managed mutual funds is not as predictable. Funds that perform in the top half of their peer group during a five-year period had a less than 50% chance of staying in the top half during the next five-year period, according to a recent S&P Dow Jones study. Investors have better odds flipping a coin than using past performance to pick winning managers.
The S&P Persistence Scorecard, released twice per year, tracks the consistency of top performing mutual funds. The Scorecard compares yearly consecutive periods with the next period, and measures performance persistence. S&P Dow Jones uses the University of Chicago’s Center for Research in Security Prices (CRSP)Survivor-Bias-Free Mutual Fund Database serves as the underlying data source.
This article provides a glimpse of the data available in this release which covers a plethora of information on investment styles, quartile rankings and time periods. I recommend reading the report to fully grasp its important message.
Table 1 summarizes the over- and under-performance results of all domestic equity funds. Performance is based on two non-overlapping five-year periods (based on halves). The first period ended in September 2008 and the second period ended in September 2013.
Table 1: All domestic funds performance over two non-overlapping five-year period
Source: S&P Persistence Scorecard December 2013. Data as of Sept. 30, 2013. Tables provided for illustrative purposes.
Only 43.37% of top-half US equity funds were able to stay in the top half over two consecutive five-year periods. The remaining 56.63% of funds either ended in the bottom half or didn’t make it through the period due to a merger or liquidation. Flipping a coin has an expected success rate of 50%.
Funds that exit the marketplace typically have poor performance prior to leaving. The Vanguard study “The mutual fund graveyard: An analysis of dead funds” compiled data on the performance of merged and liquidated funds before they ended operations. According to the study, over the 18 months leading up to closure, the median dead US equity fund fell short of a comparable index by more than four percent annually.
Table 2 breaks down the data from Table 1 into four quartiles. The best funds ending September 2008 are first quartile funds and the bottom ones are fourth quartile funds. The columns to the right highlight where those funds ended up over the second five year period, ending September 2013.
Table 2: All domestic funds performance over two non-overlapping five-year periods
Source: Source: S&P Persistence Scorecard December 2013. Data as of Sept. 30, 2013. Tables provided for illustrative purposes.
Comparing quartiles is interesting, although not encouraging. The top-performing funds did fare better than all other quartiles, even though the ability of a top manager to stay in the top quartile (22.43%) was less than a random coin toss (25%). The bottom quartile funds saw a 17.47 percent rebound to the top quartile while 36.84% died in the second five years.
Mutual funds have a difficult time outperforming their peers for an extended period of time, and even when they do, it doesn’t mean they’re beating a low-cost index fund. Nor does it mean a portfolio of actively-managed funds that own a few winning funds will outperform a portfolio of all index funds. For information on index fund portfolio performance versus active fund portfolio performance, see A Case for Index Fund Portfolios, a whitepaper that I co-authored with Alex Benke of Betterment.
Past outperformance is no guarantee of future performance. This isn’t news to experienced investors. The December 2013 S&P Persistence Scorecard illustrates the lack of performance persistence in mutual fund returns. Nonetheless, the truth must be repeated over and over again because lies are constantly being told around it.