Chasing the Performance of Active Managers is a 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.

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.

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.

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.”

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