Q.: I read one of your columns about investing overseas in which you wrote, “…past performance is actually a very poor criteria for picking funds.” What makes you say that?
—Tanner in Georgia
A.: Tanner,
Every fund you look at will present to you in multiple places a disclaimer such as “Historical performance is no guarantee of future returns“ or “Past performance is not predictive of future results.” It’s easy to brush that warning off as a CYA requirement but it is nonetheless true.
Past performance as a selection criterion makes intuitive sense. It is difficult to label a fund manager or management team as skilled if their past performance is weak. You wouldn’t hire a lawyer, a surgeon, or a stylist if you didn’t see a track record of success. Likewise, if you want a top performing fund relative to its peers or a benchmark, it is natural to look to see who has performed well.
Unfortunately, the data doesn’t support the intuition. There is a significant body of studies examining the performance of mutual funds. Top performing funds typically do not remain top performing funds. Even merely above average funds tend not to stay above average for very long. Academics say that there is no “persistence” in performance.
The most widely known study of persistence is probably S&P’s Persistence Scorecard. It is much easier reading than the many academic studies that have been done on performance. The scorecard examines how many top-performing funds remain top performers in various time frames. The results consistently confirm what academics have been saying for decades: past performance is not a good indicator of skill. In fact, it is even less reliable than guessing.
For instance, if making the top 25% of the performance charts was a reliable indicator of skill, more than 25% of the funds finishing a period in the top 25% would remain in the top 25% in the next period. The studies show consistently that less than 25% remain in the top 25% over times frames meaningful to true investors. You have a better chance of selecting a top 25% fund by selecting randomly from the all funds than from among the funds with top 25% past performance. The same dynamic appears if you seek a top 50% fund from the top 50% of past performers.
It’s important to note this because most of the money flowing into mutual funds, regardless of what category the fund is in, typically flows into funds with the highest rankings and ratings. It makes sense that we would want to know what past performance has been, but it should not be the dominant factor.
Two factors that are more important are fees and the management’s approach.
There is a high correlation between the fees and results over time. Generally lower fee funds do better than higher fee funds. Its not a perfect correlation because management style can have more influence on the results.
Its critical to know what a manager is doing with your money. For instance, a manager who is highly concentrated in just a few securities or is trying to time the markets presents a boom or bust approach that can result in high outperformance but also a higher risk of dramatic underperformance.
For most, a more diversified long term focused approach is probably a better choice. The inability to pick consistently outperforming funds, the higher fees typically associated with active funds, and other factors like tax efficiency have contributed to the popularity of index funds.
If a high-risk, high-reward approach is what you want, great but if you are not careful you may end up playing watch list whack-a-mole.
If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.
