Predicting Mutual Fund Performance

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© Brendan Ross

Past performance of fund managers is a very poor predictor of future performance.

If you read much on index investing, you’ll see variations on this theme over and over. This concept is very counterintuitive - most people are thoroughly convinced that they can pick winning managers.

Past performance works in baseball

In the sporting arena, the effectiveness of using past performance data is well-documented. Michael Lewis wrote a great book on the subject called Moneyball, in which he tracked GM Billy Beane’s extraordinary success with the underfunded Oakland A’s. Beane used statistical models to identify undervalued players, effectively “beating the market.” Although there was never a Part II written, what happened next is that much of what worked in Oakland made its way to other teams.

The stock market is different from the basebal diamond:

  • Raw Numbers. Instead of 30 teams there are 1,000,000 or more traders
  • No Fear of Change. Unlike teams, traders are immediately able (and willing) to put new ideas into practice
  • Speed to Market. No players to hire, recruit, and discipline – new trading ideas can be put into practice overnight
  • Data Availability. A hundred years of stock market data is cheaply available
  • Academic Focus. Sure, baseball has people analyzing it, but not the thousands of academics and other professionals that make careers out of scrutinizing the stock market.
  • Taxes. In baseball, if you win, you win. In trading, short term wins end up giving back 35% of their gains to the government.

It’s these criteria that make the stock market an impossible place to develop and maintain an edge, as the data show.

Here are a few studies that specifically address the inability of funds to predictably maintain top performance.

“The Persistence of Morningstar Ratings” by Mark Warshawsky, Mary DiCarlantonio, and Lisa Mullan (Journal of Financial Planning, Sept 2000). Data used was from 1997-1999

Direct quotes from “The Persistence of Morningstar Ratings”

  • Among “All Mutual Funds,” there is a fairly steady share of funds rated 4 or 5 stars – about 21%. But among the funds rated 4 or 5 stars at the end of January 1998, there was a 50.8% dropout from the top rankings over the year.
  • Similar results hold for “All Variable Annuities”…there was a 59.4% dropout rate.
  • Among funds rated ten or more years with a four- or five-star rating as of January 31, 1998, there was a 45.4% drop-off rate from the top rankings over the year.
  • [re: 1999] Similar to the previous two years, all mutual funds again had a 44.7% drop-off during 1999.

What we like about this article was the way the drop-off rate clustered around 50%, same as a coin flip.

The Barclays Study - persistence is no better than a coin flip

Barclays did a similar study in 2008. They divided the universe of mutual funds into groups based on whether they focused on large or small cap stocks, and whether they invested in growth, value, or a blend.

They looked at 15 years of data, and each year a fund outperformed the index that corresponded to their investing goals, they checked to see how it did the next year and the next two years.

Notice how the numbers cluster around 50% for Next Year and 25% for Next Two Years, same as the odds of a coin landing “heads” once or twice in a row.

Probability of Mutual Fund Performance Being Better Than Index

One more article, then we’ll refer the skeptical to our recommended reading.

You won’t win by choosing top funds based on historical performance

Let’s recall what we’re trying to prove here: You won’t win by choosing top funds based on historical performance. Since this is THE PRIMARY WAY people choose mutual funds, any evidence that this technique won’t work should be pretty shattering.

DFA did a study of the top 30 funds for rolling 5-year periods ranging from 1970 through 1998. The first row of the chart shows that the top 30 funds in 1970-1974 then went on to underperform their index by -0.99% through the end of 1998 (i.e. 24 years of underperformance at -0.99% per year).

Performance of Top 30 Funds vs Index

This study cleverly demonstrates that these top performing funds didn’t just have a painful next year, but went on for decades to underperform their index. This is sobering testimony to the inability of funds to live up to their historical track records.

Expenses matter

There is one characteristic of mutual funds that shows a direct correlation with returns. Don’t expect to be surprised: it’s the expense ratio. As you know, index funds have much lower expense ratios than actively managed funds.

If you’re not familiar with how high expense ratios actually are, try the following:

  • Actively Managed Funds
    Go to the Morningstar Fund Screener
    Using the top pulldown, choose a fund group like “Domestic Stock”
    Scan the expense ratios
  • Index Funds
    Go to the DFA website and download their prospectus
    Go to page 27 in the booklet, which is page 30 of the PDF

Remember that, including inflation, the equities market has increased by 8.4% since 1926. Losing 1.5% to a mutual fund manager is significant. If you haven’t yet finished the main article on Active vs Index Investing, please review the graphs that show the painful bite that fees and taxes have on an actively managed portfolio.