By LARRY SWEDROE
“If you want to see the greatest threat to your financial future,
go home and take a look in the mirror.”
— Jonathan Clements
If you are like most people you probably have wondered why you have done some really foolish things. Perhaps you have used a folding chair as a stepladder, tried cleaning an oven with the burners still on, or left your car with the engine still running (something I have done twice). The facts of life are that even smart people occasionally do dumb things — it is one of the things that makes us human. When it comes to investing most of us make mistakes, often caused by behavioural errors like overconfidence. Being overconfident can cause us to take too much risk, trade too much and confuse the familiar with the safe. Those are explainable errors. But here is one that I find hard to explain.
Most smart people don’t ignore the Surgeon General’s warning about the hazards of smoking cigarettes. So why do they ignore the SEC’s required warning that accompanies all mutual fund advertising, “Past performance does not guarantee future results.?” Despite both an overwhelming body of evidence, including the annual Standard & Poors Active Versus Passive Scorecards, that demonstrates that the past mutual fund returns of active managers are not prologue and the SEC’s warning, investors still flock to funds that have performed well in the recent past. Fund companies exploit and encourage this by advertising their top-performing funds. And studies such as the 2020 research paper Non-Fundamental Demand and Style Returns show that fund flows follow advertising.
We’ll review some of the most powerful evidence on performance persistence—evidence that I hope will lead you to ask: Why do investors ignore the evidence? We’ll begin with the 2017 study Does Past Performance Matter in Investment Manager Selection? The authors examined “whether selecting managers based on recent simple outperformance against the stated benchmark (the dominant manager selection heuristic) can lead to subsequent simple outperformance against the benchmark (the desired outcome for most institutional investors).” To simulate the impact of the popular manager selection heuristic, they compared the performance of hypothetical pension portfolios that follow policies that mandate investing in products based on recent benchmark-adjusted returns.
The authors started with the commonly employed “winner strategy”, defined as follows: At the beginning of each three-year period, investors purchase equal positions in products that rank in the top decile of benchmark-adjusted returns. At the end of three years, monies are reallocated to a new portfolio that is once again equal-weighted among the top-decile performers.
They then compared the investment results of their winner strategy with those of a “median strategy,” whose three-year asset allocation policy is to invest in products that rank between the 45th and 55th percentile of benchmark-adjusted returns. They also examined the counterintuitive “loser strategy,” which follows the same procedure but invests in products that rank in the bottom decile of benchmark-adjusted returns.
The winner-strategy bucket would generally consist of fund managers that investment consultants would recommend to their pension clients. Managers in the loser-strategy bucket would generally be put on a “watch list” and actively replaced in client portfolios by managers on the recommended list.
Finally, they also compared the investment performance produced by an unorthodox strategy of investing in products that underperformed their benchmarks by more than 1 percent per year, as well as the even more extreme case of investing in products that underperformed their benchmarks by more than 3 percent per year. These portfolios provide insight into the impact of the common manager firing heuristic. Their sample excluded funds that did not have at least $1 billion in AUM and also those that ranked in the top decile of expense ratio (research shows that expensive mutual funds tend to be persistent underperformers because of costs). Their study covers the period from 1994 through 2015. The following is a summary of their findings:
- The average benchmark-adjusted return for the median strategy beats that of the winner strategy by 1.32 percentage points per year (-1.07 percent versus -2.39 percent), and the loser strategy outperforms the median strategy by 0.96 percentage points per year (the loser strategy had a benchmark-adjusted return of -0.11). Thus, the loser strategy outperformed the winner strategy by 2.28 percentage points per year.
- In addition to benchmark-adjusted returns, the median strategy outperforms the winner strategy across all other performance metrics commonly employed in academic studies while the loser strategy outperforms the median strategy.
- The Sharpe ratio of the median strategy is 0.42 versus 0.25 for the winner strategy, while the loser strategy produced a Sharpe ratio of 0.48. Thus, investors would have nearly doubled their mean-variance efficiency by switching from chasing winners to investing in loser funds.
- The CAPM alpha generated by the median strategy beats that of the winner strategy by a statistically significant 2.76 percentage points per year (-0.85 percent versus -3.61 percent) and its Carhart four-factor (market beta, size, value and momentum) alpha beats that of the winner strategy by a statistically significant 1.03 percentage points a year (-2.16 percent versus -3.19 percent). The loser strategy managed to do even better, producing a CAPM alpha of just -0.11 and a Carhart four-factor alpha of -0.17, though neither was statistically significant.
Similar results were found when examining the performance of the extreme loser portfolios. “At the 3% threshold, the fired funds outperform the kept funds by over one percentage point per year based on benchmark-adjusted return, raw return, CAPM alpha, and Carhart four-factor model alpha. The Sharpe ratios indicate that the fired funds also exhibit greater mean-variance efficiency than their counterparts. The results are largely similar when we use a 1% threshold in place of the 3% threshold. Once again, the fired funds outperform the kept funds across all performance metrics.”
For example, they found the funds that underperformed by more than 1 percent (fired managers) produced four-factor alphas of -0.69 percent, which compares favourably to the -1.88 percent alpha of funds that did not underperform by more than 1 percent (managers who were kept). For funds that underperformed by more than 3 percent, the four-factor alpha was -0.48 percent versus -1.64 percent for those that did not underperform by more than 3 percent.
As a test of robustness, they found similar results using a two-year evaluation period instead of three years. They also found similar results when they eliminated the $1 billion AUM requirement, and when they looked at only institutional share classes (which have lower costs). They even found the same results when looking at funds by benchmark performance decile (in general, moving from the funds in the best-performing deciles to the worst, performance became worse on both a raw and risk-adjusted basis). Such outcomes help to explain the often-reported “performance gap”—the finding that, on average, performance-chasing behavior can cause investors to underperform the very funds in which they invest.
Their findings led the authors to conclude: “We find that the common selection methodology turns out to be a detriment to performance.” They added: “The greater benchmark-adjusted return to investing in ‘loser funds’ over ‘winner funds’ is statistically and economically large and is robust to reasonable variations in the evaluation and holding periods, as well as to standard risk adjustments. We also found that the standard practice of firing managers who have recently underperformed actually eliminates those managers that are more likely to outperform in the future.”
These findings are entirely consistent with previous research. Take note of the publication dates of the studies cited below. You’ll see that the evidence on using past performance to select actively managed funds has been there for a long time for all to see. Yet, the evidence continues to be ignored by a large majority of investors, both institutional and individual.
Supporting evidence
Rob Bauer, Rik Frehen, Hurber Lum and Roger Otten, authors of the 2008 study The Performance of U.S. Pension Plans, examined the performance of 716 defined benefit plans (over the period from 1992 through 2004) and 238 defined contribution plans (over the period from 1997 through 2004). They found that returns relative to benchmarks were close to zero. They also found no persistence in performance.
Importantly, the authors also found neither fund size, degree of outsourcing or company stock holdings were factors driving performance. This refutes the claim that large pension plans are handicapped by their size. Smaller plans did no better. They concluded: “We show striking similarities in net performance patterns over time, which makes skill differences highly unlikely.”
Bauer, Frehen, Lum and Otten also studied the performance of mutual funds, adding to our body of evidence on them. As you should expect, the news for individual investors is even worse. While pension plans failed to outperform market benchmarks, on a risk-adjusted basis mutual funds underperformed pension plans by about 2 percent per year. Pension plans are able to use their size (negotiating power) to minimise costs and reduce the risks of any conflicts of interest between fund managers and investors. The authors attributed the underperformance to the incremental costs incurred by mutual fund investors.
Counterproductive activity
The 2008 study The Selection and Termination of Investment Management Firms by Plan Sponsors by Amit Goyal and Sunil Wahal provide even further evidence on the inability of plan sponsors to identify investment management firms that will outperform the market after they are hired. In their study, Goyal and Wahal examined the hiring and firing of investment management firms by plan sponsors (public and corporate pension plans, union pension plans, foundations and endowments). They built a dataset of the selection and termination decisions of about 3,400 plan sponsors from 1994 to 2003. The data represented the allocation of over $627 billion in mandates. The following is a summary of their findings:
- Plan sponsors hire investment managers after large, positive excess returns coming up to three years prior to hiring.
- Such return-chasing behavior does not deliver positive excess returns thereafter.
- Post-hiring, excess returns are indistinguishable from zero.
- Plan sponsors terminate investment managers after underperformance, but the excess returns of these managers after being fired are frequently positive.
- If plan sponsors had stayed with the fired investment managers, their returns would have been larger than those actually delivered by the newly hired managers.
It is important to note that the above results did not include any of the trading costs that would have accompanied transitioning a portfolio from one manager’s holdings to the holdings preferred by the new manager. The bottom line: All of the activity was counterproductive.
Having reviewed the evidence, it’s time to return to our question: Why do investors ignore both the warning and the evidence?
Why are warnings worthless?
The study Worthless Warnings? Testing the Effectiveness of Disclaimers in Mutual Fund Advertisements provided some interesting results. The authors created an experiment in which participants were shown a version of a performance advertisement for a mutual fund that had outperformed its peers in the past. They were then asked about their propensity to invest in the fund and about their expectations regarding the fund’s future returns. Versions of the advertisement differed in the strength and prominence of the disclaimer contained in the advertisement.
The authors found that “people viewing the advertisement with the current SEC disclaimer were just as likely to invest in a fund, and had the same expectations regarding a fund’s future returns, as did people viewing the advertisement with no disclaimer whatsoever.” The authors concluded: “the SEC-mandating disclaimer is completely ineffective. The disclaimer neither reduces investors’ propensity to invest in advertised funds nor diminishes their expectations regarding the funds’ future returns.” They concluded: “The current disclaimer fails because it is too weak.” It fails because “it only conveys that high past returns don’t guarantee high future returns and that investors in the fund could lose money, things that almost all investors already know. It fails to convey what investors really need to understand: high past returns are a poor predictor of high future returns.”
The authors did find “that a stronger disclaimer—one that informs investors that high fund returns generally don’t persist (they are often a matter of chance)—would be much more effective.”
Investors are also ignoring the American Law Institute’s Prudent Investor Rule that states: “there is little correlation between fund managers’ earlier successes and their ability to produce above-market returns in subsequent periods.”
There are hundreds of studies on the subject of past performance of money managers as a predictor of future performance. The following from the March 19, 1999 issue of Forbes effectively summarizes the conclusions of a publication that regularly touts top performing funds: “Despite the solemn import that fund companies attribute to past performance, there’s no evidence that the 4 percent who beat the index owe their record to anything other than random statistical variation. The whole industry is built up around a certain degree of black magic.” Fortune continued: “Despite volumes of research attesting to the meaninglessness of past returns, most investors (and personal finance magazines) seek tomorrow’s winners among yesterday’s. Forget it. The truth is, much as you wish you could know which funds will be hot, you can’t — and neither can the legions of advisers and publications that claim they can.”
If not past performance…?
There’s an axiom in finance that when the evidence (past performance of active funds is not prologue) conflicts with the theory, no matter how logical and intuitive it may be, throw out the theory. Unfortunately, most investors continue to ignore the evidence that makes it clear a policy of hiring recently outperforming managers and firing recently underperforming managers is a losing strategy. The results you have seen in the research pose a significant challenge for investors who continue to base decisions on beliefs that run counter to the evidence.
The bottom line is that so many investors are doing the same thing over and over again and expecting a different outcome. Most seem to never stop and ask the question: If the managers I hired based on their past outperformance have underperformed after being hired, why do I think the new managers I hire to replace them will outperform if I am using the very same criteria that has repeatedly failed? And, if I am not doing anything different, why should I expect a different outcome? I’ve asked these very questions, and never once received an answer — just blank stares.
The practical implication is that investors should change the criteria they use to select managers. Instead of relying mainly, if not solely, on past performance, they should use criteria such as fund expenses and the fund’s degree of exposure to well-documented factors (such as size, value, momentum, profitability and quality) that have been shown to have provided premiums. These premiums should be: persistent, pervasive, robust to various definitions, implementable (they survive transaction costs) and have intuitive explanations for why they should persist.
A set of criteria like that will almost certainly lead investors to avoid actively managed funds and increase their likelihood of superior results.
The moral of the tale
Whether the advice comes from the Surgeon General, the SEC or the American Law Institute, smart people know that it should not be ignored. They also know that if they choose to ignore the advice they do so at their own peril.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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