Wishing Upon A Star Manager Doesn’t Work
Did you see that!? Another amazingly bright mutual fund manager burned out. After a streak of greatness, his fund’s performance went pitch black. Missed it? Just wait — they’ll be plenty more. The mutual fund universe is full of shooting stars. In fact, picking a manager based on his or her superior past return more often results in sub-par returns than a repeat performance.
Persistence studies analyze the returns of mutual funds over two independent periods to measure the link between past return to future return. Standard and Poor’s has been documenting the results in their S&P Persistence Scorecard for several years. The results typically show little if any correlation between past performance and future returns. The June 2013 version is expected next week.
Morningstar recently published a persistence study titled The Percentile Trap. It analyzed the following categories of U.S. open-ended mutual funds during 11 five-year periods beginning in April of 1998 to March 2013: Large Value, Large Growth, Mid-Blend, Small Value and Small Growth. Jeffrey Ptak, president and CIO of Morningstar Investment Services, reported that only 10% to 20% of top-quartile funds in each category remained in the top quartile over the subsequent five-year period. In contrast, Ptak found that on average, 20% to 30% of top quartile funds from the previous five years fell to the bottom quartile in performance in the next five years.
Maintaining consistently high performance is so difficult for fund managers that less than half (10% to 20%) of the top quartile funds were even able to stay in the top half over the next five years. Approximately 30% to 40% of funds in each category finished in the top half after accounting for funds that go out of business, merged with another fund or changed style categories.
The Morningstar article provided an interesting analysis of where winning funds come from. They found a majority of winning funds in each category were new or new to that category. Of the funds that were in existence and in the same category for long time, more bottom performing funds become top quartile funds in the second five-year period as the winning funds of the past fell out of favor.
I’ve been interested in persistence studies since Mark Carhart published the first detailed analysis on the subject in 1997, On Persistence in Mutual Fund Performance. The numbers shift around a bit from one period to another, but in total, the link between past performance and future return is almost nonexistent. The best way to treat past performance is as random. There’s an equal chance for a winning fund to be in the top, bottom, or go out business over the next period.
Past performance is a poor indication of future results as every learned investor knows. Yet this remains the primary factor used by individuals and advisers to select fund managers. 71% of current owners rank past performance as “very influential” or “somewhat influential” when selecting mutual funds, according to survey conducted by the Consumer Federation of America (CFA) and funded by the NASD Investor Education Foundation.
The fact that most people believe that past performance can predict future returns is a triumph of marketing over substance. We see mutual fund companies heavily promote past performance in newspapers and magazines, on television and radio, and all over the Internet. The micro-print under this performance always includes the required SEC disclosure about using past performance, but that’s not what people see. They see the BIG and BOLD print promoting a fund’s past return, its high rating based on past performance, and talk about how expert the managers are. In five years, these funds will fade into obscurity and there will be a different set of best past performers.
Past performance does not provide useful information about future performance. Wishing upon a star is a fine fantasy for children, but it doesn’t work for adults who are trying to earn a fair return from their mutual funds.