Your Money: Mutual Fund Investing

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The Ghost of Performance Past

By Jonathan E. Lederer, CFA

If Ebenezer Scrooge were alive, he’d no doubt be reading the plethora of financial publications touting the year’s hottest mutual funds. 
    It’s no coincidence the best-performing funds experience subsequently high cash inflows, while poor performers suffer a cash exodus. However, in light of a recently released Standard & Poor’s study showing few funds consistently outperform their peers, Scrooge might find his Ghost of Christmas Future pointing at the disclaimer: “Past performance is no guarantee of future results.”
    Is this strategy of piling into the best-performing funds really effective? Given the latest Dalbar “Quantitative Analysis of Investor Behavior” report, showing the average equity mutual-fund investor achieved only one-third of the S&P 500’s annual return over the last 20 years, one cannot help but wonder whether the strategy of chasing the hottest funds contributed to this subpar performance.
    S&P last year began compiling its Mutual Fund Performance Persistence Scorecard. The scorecard, which is released semiannually and corrects for fund-survivorship bias, tracks the consistency of top-performing funds over one-, three-, and five-year periods.
    The scorecard for midyear 2006 found a small percent of funds managed to perform consistently in the top quartile or top half of their peer groups. The study showed that over the last five consecutive 12-month periods:
• Only 1.1 percent of U.S. large-cap funds, 0 percent of mid-cap funds, and 0.8 percent of small-cap funds maintained a top-quartile ranking relative to their peers.
• Only 10.8 percent of large-cap, 7.9 percent of mid-cap, and 7.7 percent of small-cap funds maintained a top-half ranking.
Looking at a longer time period, the scorecard analyzed the top funds for the five-year period ending June 2001 and found that over the next five years (ending June 2006):
• Only 17.5 percent of large-cap, 6.8 percent of mid-cap, and 18.7 percent of small-cap funds repeated their performance in the top quartile.
• Only 36.3 percent of large-cap, 26.4 percent of mid-cap, and 47.0 percent of small-cap funds maintained their top-half rankings.
    The five-year data are below what would be expected in a random sample, as one would expect a 25 percent top-quartile and a 50 percent top-half repeat rate. For the five consecutive 12-month periods, though, some results are slightly higher than random expectations.
The scorecard has shown similar results since its launch in July 2005. According to Rosanne Pane, S&P’s mutual fund strategist, the findings show “it’s very difficult, year after year, for funds to maintain the top level of performance relative to peers.”

Importance of Tenure
If past performance alone is not highly predictive of future fund results, what criteria should investors consider?
S&P analyzed the small number of funds that maintained consistently high rankings and found management tenure was a key distinguishing factor. For example, the average tenure of a large-cap manager who retained a top-half ranking during the past two nonoverlapping five-year periods was almost 12 years, more than double the 5.6-year average tenure for the entire large-cap universe. S&P’s Pane believes these seasoned managers “tend to be more successful because they have longer-term perspectives, have experienced various market-cycle environments and typically don’t get caught up in bubbles or other short-term hype.”
S&P also determined persistent top-half performers had lower operating-expense ratios and were more diversified, holding more stocks in their portfolios. But these characteristics were not as much of a differentiator as management tenure.
    Pane adds “there’s nothing wrong with looking at past performance, but investors have to do their research. They should ensure the fund-management team that delivered the solid long-term performance is still at the helm and that the fund costs are on the lower end.”

(Un)conventional Wisdom
When considering the data in the scorecard along with S&P’s Index Versus Active reports, which show very few funds consistently outperform their benchmark indexes, one might conclude conventional wisdom should instead dictate the use of low-cost index funds. Pane, who helps compile both the scorecard and SPIVA reports, agrees to an extent. She recommends indexing a large portion of a portfolio and then investing the remainder in lower-cost funds that have successful, well-tenured management teams in place. Investors heeding this advice may be less likely to mutter “bah, humbug” when they see their year-end portfolio results. 

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