Everyone loves a winner, so it’s only natural that when they’re looking for funds to invest in, people veer towards those that are on a good run. Of course, the fund industry is acutely aware of this all-too-human tendency; hence the emphasis in its PR and advertising on recent strong performers.
But, from an investment point of view, chasing what’s hot and putting your trust in the latest “star” manager is a thoroughly bad idea — a fact reinforced by a new study from Morningstar.
Researchers analysed fund performance across 14 different categories and over a range of time periods. It also looked at more recent data than many similar studies on this issue. The resulting paper, Performance Persistence Among US Mutual Funds, includes three main findings:
- Over the long term, there is no meaningful relationship between past and future fund performance.
- Although there is some evidence that relative fund performance persists in the short-term, this appears to be attributable to greater exposure to momentum stocks rather than superior manager skill.
- In most cases, the odds of picking a future long-term winner from the top-performing quintile in each category aren’t materially different than selecting from the bottom quintile.
What studies such as this continue to tell us is that investors and advisers must resist any temptation from the industry — or the media — to focus on short-term performance.
Morningstar found that although funds in the first quintile tended to have a higher success rate than funds in the fifth quintile over the following 12-month period, there was little distinction between the two over periods of anything longer than a year. Indeed, in many categories, bottom-quintile funds subsequently fared better than top-quintile funds.
On average, in the large-blend category, just 36% of the funds that made it into the top quintile in one ten-year period managed to land in the top half of their surviving peers during the following ten-year period. In other words, a spell of sustained outperformance was often the precursor to a losing streak.
Investors really need to learn that a one-year time period is completely irrelevant. A 25-year old today might not retire for another 45 or 50 years, or even longer. In that context, a marginal outperformance over the next 12 months means nothing at all. Over any meaningful period of time, only a tiny fraction of actively managed funds succeed in beating the index net of costs.
I would never say never use an active fund. But for me, there are nowhere near enough funds that are beating the market with any degree of consistency to warrant ever paying the significant premium they charge. Until that changes — and until someone can demonstrate the ability to predict future winners with a modicum of accuracy — I suggest you refuse to dance the industry’s tune.
Buy and hold a globally diversified portfolio of low-cost index funds. Job done.