Finish this sentence: “Past performance is…”
“…random.”
Not what you were expecting? Most folks would have finished the sentence “…not an indicator of future outcomes.” Or something similar.
It’s interesting to note that nearly every investor has been so brainwashed to this statement that they don’t reall
y ”hear” it anymore. It’s in one ear and out the other and despite the warning, most investors and advisers demonstrate their conviction that the past performance of a mutual fund DOES matter by continuing to construct financial plans, asset allocation targets and efficient frontiers around the practice of analyzing the past to predict the future.
Actually, past performance may say something about the future of a mutual fund, but not in the way one would expect. A recent Standard & Poor’s research paper titled, “Does Past Performance Matter?” points out that the bottom quartile of mutual funds by performance are consistently the most likely to go out of business, be shut down, or be bought up and merged. Logically, I can understand this. Since investors continue to focus on past performance when a fund performs poorly they are more likely to extract their money from that fund. When a fund’s outflows drain it to a certain point, it is no longer profitable to keep running the fund. Close it, sell it, merge it.
What about the best of the rest? Here are some facts from S&P’s recent report:
- 1.7% of large-cap funds, 2.2% of mid-cap funds, and 4.6% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Random expectations would suggest a rate of 6.25%.
- 18.5% of large-cap funds with a top quartile ranking over the five years ending March 2005 maintained a top quartile ranking over the next five years. Only 12.7% of mid-cap funds and 25.0% of small-cap funds maintained a top quartile performance over the same period. Random expectations would suggest a repeat rate of 25%.
The report looks at a number of different time frames and durations and IN EVERY EXAMPLE one would have achieved better investment results by randomly selecting a mutual fund.
If you turn this analysis around, the conclusion is that selecting a mutual fund to invest in by researching and ranking historical returns will actually encourage a less successful investment experience going forward than simply throwing a dart.
We’ve always avoided mutual funds for our clients because of the costs of them, now we have another reason.
