The Mutual Fund Landscape - Part Two
The search for winners
The competitive landscape makes the search for future winners a formidable challenge. Confronted with so many fund choices—and lacking an investment philosophy to inform their search—some investors may resort to using track records as a guide to selecting funds, reasoning that a manager’s past outperformance is likely to continue in the future.
Does this assumption pay off? The research offers evidence to the contrary.
The two charts below illustrate the lack of persistence in outperformance. Three-, five-, and 10-year mutual fund track records are evaluated through the end of 2009, and funds that beat their respective benchmarks are re-evaluated in the subsequent five-year period ending December 31, 2014.
Past performance vs. subsequent performance—Equity Funds
Past performance vs. subsequent performance—Fixed Income Funds
The samples includes funds at the beginning of the three-, five-, and 10-year periods, ending in December 2009 (the "initial period"). The graph shows the proportion of funds that outperformed and underperformed their respective benchmarks (i.e., winners and losers) during the initial periods. Winning funds were re-evaluated in the subsequent period from 2010 through 2014, with the graph showing the proportion of outperformance and underperformance among past winners. (Fund counts and percentages may not correspond due to rounding.) Past performance is no guarantee of future results. See Data appendix for more information. US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago.
Only a small percentage of the beginning equity funds outperformed in the initial periods—and subsequent performance was not much better. For example, only 25% of the equity funds with past outperformance during the initial three- year period (2007–2009) continued to beat their benchmarks in the subsequent five-year period (2010–2014).
Finding past winners does little to help investors identify future outperforming funds. The
results for equity funds with good five- and 10- year track records were similar—less than a third beat their benchmarks in the subsequent period.
The past returns of fixed income funds do not provide insight into future outperformance, either. The number of bond funds with good track records is sparse, with no more than 20% of the beginning funds showing benchmark- beating returns during the initial three-, five-, and 10-year performance periods.
Less than 40% of the three- and five-year past winners continued to outperform in the subsequent five years, and 52% of the 10-year winners outperformed.
The results for both winning equity and fixed income funds show that past outperformance is not a reliable indicator of future outperformance. Even past winners are likely to underperform in the future.
This lack of persistence among winners suggests that gaining a consistent informational advantage is very difficult. Many smart professionals are striving to gather morsels of information to help them identify pricing mistakes. But this competition means that public information is quickly reflected in market prices, leaving few opportunities to exploit the knowledge for profit.
Some fund managers might be better than others, but they are hard to identify in advance using track records alone. Stock and bond returns contain a lot of noise, and impressive track records often result from good luck. The assumption that past outperformance will continue often proves faulty, leaving many investors disappointed.
Next Week: The Impact of Costs
Data appendix
US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago.
Certain types of equity and fixed income funds were excluded from the performance study. For equities, sector funds and funds with a narrow investment focus, such as real estate and gold, were excluded. Money market funds, municipal bond funds, and asset-backed security funds were excluded from
fixed income.
Funds are identified using Lipper fund classification codes. Correlation coefficients are computed
for each fund with respect to diversified benchmark indices using all return data available between January 1, 2000, and December 31, 2014. The index most highly correlated with a fund is assigned as its benchmark. Winner funds are those whose cumulative return over the period exceeded that of their respective benchmark. Loser funds are funds that did not survive the period or whose cumulative return did not exceed their respective benchmark.
Expense ratio ranges: The ranges of expense ratios for equity funds over the five-, 10-, and 15-year periods are 0.01% to 4.89%, 0.01% to 4.53%, and 0.04% to 4.83%, respectively. For fixed income funds, ranges over the same periods are 0.01% to 2.78%, 0.05% to 2.55%, and 0.03% to 3.66%, respectively.
Portfolio turnover ranges: Ranges for equity fund turnover over the five-, 10-, and 15-year periods are 1.0% to 1,499.4%, 1.0% to 1,524.0%, and 2.0% to 2,400.4%, respectively.
Benchmark data provided by Barclays, MSCI, Russell, Citigroup, BofA Merrill Lynch, and S&P. Barclays data provided by Barclays Bank PLC. MSCI data © MSCI 2015, all rights reserved. Russell data © Russell Investment Group 1995–2015, all rights reserved. Citigroup bond indices © 2015 by Citigroup. The BofA Merrill Lynch index is used with permission; © 2015 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Merrill Lynch, Pierce, Fenner & Smith Incorporated is a wholly owned subsidiary of Bank of America Corporation. The S&P data is provided by Standard & Poor’s Index Services Group.
Benchmark indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.
ENDNOTES
- Bid-ask spread is the difference between the highest price a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it.
- Fixed income funds are excluded from the analysis because turnover is not a good proxy for fixed income trading costs.