Chasing the Performance of Active Managers is a Losing Proposition

Welcome to MutualFunds.com

Please help us personalize your experience and select the one that best describes you.

Your personalized experience is almost ready.

Join other Individual Investors receiving FREE personalized market updates and research. Join other Institutional Investors receiving FREE personalized market updates and research. Join other Financial Advisors receiving FREE personalized market updates and research.
Not interested

Thank you!

Check your email and confirm your subscription to complete your personalized experience.

Thank you for your submission

We hope you enjoy your experience

Channels

Fixed Income Channel

Fixed income news, reports, video and more.

Municipal Bonds Channel

Municipal bonds news, reports, video and more.

Practice Management Channel

Practice management news, reports, video and more.

Portfolio Management Channel

Portfolio management news, reports, video and more.

Retirement Channel

Retirement news, reports, video and more.

Strategists Channel

Learn from industry thought leaders and expert market participants.

Calvert’s Advisor Resource Center

Deepen your understanding of Responsible Investing and learn how it can potentially help you build a more successful practice.

Screener
Funds
Categories

18 Most Popular Mutual Fund Categories

Canada Equity Funds Global Equity Funds Micro-Cap Equity Funds Precious Metals Equity Funds Water Equity Funds
Consumer Staples Funds US Funds China Funds Israel Funds Retirement Income Funds
Bear Market Strategy Funds Market Neutral Funds Alternative Funds Commodity Funds
Currency Funds Mortgage-Backed Securities Funds High Yield Municipal Bond Funds Money Market Funds

View All Categories

Fund Companies

15 Most Popular Fund Companies

Vanguard Fidelity Investments American Funds T. Rowe Price
JPMorgan BlackRock Dimensional Fund Advisors Franklin Templeton
PIMCO Goldman Sachs Federated MFS
Charles Schwab John Hancock Invesco

View All Fund Companies

15 Most Popular Fund Company Quick Screens

Vanguard Index Funds Vanguard Retirement Funds Vanguard Money Market Funds Fidelity Index Funds
Fidelity Money Market Funds Fidelity Blue Chip Growth Equity Funds American Balanced Funds T. Rowe Price Blue Chip Growth Equity Funds
Blackrock Global Allocation Funds Franklin Income Funds PIMCO Income Funds Charles Schwab Index Funds
Charles Schwab Money Market Funds Invesco Real Estate Funds Matthews Asia International Funds

View All Fund Company Quick Screens

Articles

Articles

Mutual Fund Education Index Fund Center Domestic Stock Funds International and Global Stock Funds Target-Date Funds
Fixed-Income Funds Asset Allocation Specialized Funds Enhanced Index Funds Actively Managed Funds
No-Load Funds Bond Funds Equity Funds Hybrid Funds Resources For Mutual Fund Investors
Q&As and Interviews Lighter Side: Quizzes and More Taxation Expert Analysis and Commentary News
Advisors

Advisor Access

Receive email updates about fund flows, news, upcoming CE accredited webcasts from industry thought leaders and more.

Practice Management

Content focused on helping financial advisors build successful client relationships and grow their business.

Portfolio Management

Content geared towards helping financial advisors build better client portfolios.

Expert Opinion

Get insights on the industry trends and investment news from leading fund managers and experts.

Advisor Access
You have successfully subscribed to Advisor Access. Thank you!
Help us personalize your experience.
Which type of investor describes you best?
Help us personalize your experience.
What is your AUM?
Knowing your investable assets will help us build and prioritize features that will suit your investment needs.

Congratulations on personalizing your experience.

Email is verified. Thank you!

Chasing the Performance of Active Managers is a Losing Proposition

Larry Swedroe

|

burning money for losing proposition
Despite SEC warnings that past performance does not guarantee or predict future results (in other words, the past is not prologue), the most common approach among individual investors for selecting mutual funds is to rely on prior-period returns.

An Asterisk Next to the Star

Many investors depend on a service from Morningstar, which rates funds using a star system similar to the one employed by film critics. These investors must believe that the number of stars earned by a mutual fund possess predictive value, as one study found that an amazing 97 percent of fund flows went into four- and five-star rated funds. Three-star funds experienced outflows. It’s no accident that advertisements touting four- and five-star ratings can be found almost everywhere.
Assets persistently flow disproportionately to the recent winners and away from the recent losers. Unfortunately for investors, this approach has consistently produced below-benchmark returns.

History Does Not Predict Futures

Morningstar itself conducted a study covering every active and dead fund that existed for the 19-year period ending January 2009. They calculated the returns of funds compared to the returns of their peer group (funds in the same asset class) based on each fund’s rolling three-year return. To determine if the past is prologue, they compared the ranking of each top-quartile fund with its ranking in the next non-overlapping three-year period. Morningstar concluded: “We find scant evidence to suggest that three-year top quartile returns rankings, a commonly cited litmus test, are reliable predictors of future outperformance.”
Making matters worse, Morningstar also found that among large-cap funds, top-quartile rankings were even less predictive when funds accounted for an outsized share of assets in their category (though they didn’t find that this held true for mid-cap and small-cap funds as well).
Finally, Morningstar researchers discovered that in periods when top-quartile large-growth funds were “well above average” (defined as one standard deviation or more above the historical average percentage of category assets), nearly two-thirds of those top-quartile funds proceeded to finish in the bottom half, or leave the category altogether.

No Predictive Value

Said another way, the SEC warning that “past performance is not a guarantee of future results” is misleading. Instead, the regulatory agency’s required disclaimer should actually read: “Past performance has no predictive value as to future returns.” This could, however, be appended to include the fact that poorly performing funds with high expense ratios are likely to repeat their poor performance.

In what is a truly sad situation, another study found that while smart people don’t ignore the Surgeon General’s warning about the hazards of smoking cigarettes, they do disregard the SEC’s required warning that accompanies all mutual fund advertising.

The study — “Worthless Warnings? Testing the Effectiveness of Disclaimers in Mutual Fund Advertisements” — provided some interesting insights. The authors write: “Participants in the experiment were shown a version of a performance advertisement for a mutual fund that had outperformed its peers in the past and then were 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.”
They then 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.”
The authors went on to explain that “the current disclaimer fails because it is too weak” and 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 emphasis is mine.

Interestingly, 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.”

The Bottom Line

… if you are still relying on the past performance of actively managed funds to build your investment plan, it’s time to stop.

Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Popular Articles

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Read Next

burning money for losing proposition

Chasing the Performance of Active Managers is a Losing Proposition

Larry Swedroe

|

Despite SEC warnings that past performance does not guarantee or predict future results (in other words, the past is not prologue), the most common approach among individual investors for selecting mutual funds is to rely on prior-period returns.

An Asterisk Next to the Star

Many investors depend on a service from Morningstar, which rates funds using a star system similar to the one employed by film critics. These investors must believe that the number of stars earned by a mutual fund possess predictive value, as one study found that an amazing 97 percent of fund flows went into four- and five-star rated funds. Three-star funds experienced outflows. It’s no accident that advertisements touting four- and five-star ratings can be found almost everywhere.
Assets persistently flow disproportionately to the recent winners and away from the recent losers. Unfortunately for investors, this approach has consistently produced below-benchmark returns.

History Does Not Predict Futures

Morningstar itself conducted a study covering every active and dead fund that existed for the 19-year period ending January 2009. They calculated the returns of funds compared to the returns of their peer group (funds in the same asset class) based on each fund’s rolling three-year return. To determine if the past is prologue, they compared the ranking of each top-quartile fund with its ranking in the next non-overlapping three-year period. Morningstar concluded: “We find scant evidence to suggest that three-year top quartile returns rankings, a commonly cited litmus test, are reliable predictors of future outperformance.”
Making matters worse, Morningstar also found that among large-cap funds, top-quartile rankings were even less predictive when funds accounted for an outsized share of assets in their category (though they didn’t find that this held true for mid-cap and small-cap funds as well).
Finally, Morningstar researchers discovered that in periods when top-quartile large-growth funds were “well above average” (defined as one standard deviation or more above the historical average percentage of category assets), nearly two-thirds of those top-quartile funds proceeded to finish in the bottom half, or leave the category altogether.

No Predictive Value

Said another way, the SEC warning that “past performance is not a guarantee of future results” is misleading. Instead, the regulatory agency’s required disclaimer should actually read: “Past performance has no predictive value as to future returns.” This could, however, be appended to include the fact that poorly performing funds with high expense ratios are likely to repeat their poor performance.

In what is a truly sad situation, another study found that while smart people don’t ignore the Surgeon General’s warning about the hazards of smoking cigarettes, they do disregard the SEC’s required warning that accompanies all mutual fund advertising.

The study — “Worthless Warnings? Testing the Effectiveness of Disclaimers in Mutual Fund Advertisements” — provided some interesting insights. The authors write: “Participants in the experiment were shown a version of a performance advertisement for a mutual fund that had outperformed its peers in the past and then were 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.”
They then 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.”
The authors went on to explain that “the current disclaimer fails because it is too weak” and 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 emphasis is mine.

Interestingly, 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.”

The Bottom Line

… if you are still relying on the past performance of actively managed funds to build your investment plan, it’s time to stop.

Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Popular Articles

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Read Next

Advertisement

×

Wait! Do you know all the important aspects of mutual funds?

×

Free Advisor Access newsletter emailed to you.

Receive free and exclusive email updates for financial advisors about best performers, news, CE accredited webcasts and more.

Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Disclaimer: By registering, you agree to share your data with MutualFunds.com and opt-in to receiving occasional communications about projects and events. The contents of this form are subject to the MutualFunds.com Privacy Policy. You can unsubscribe at any time.

X