What Does Past Performance Mean?
Stock Picking Skill?
Investors tend to chase performance by following the previous year’s winners. Funds increase their assets under management and boost their profits by touting their previous one, three, or five-year successful track records. Does choosing these “hot” actively managed funds repeat their success in a subsequent period?
Take a look at this chart showing the subsequent five-year performance of the previous five year’s top 25% (top-quartile) actively managed US equity funds:
The stacked graph at left sorts the entire US equity fund universe by cumulative 5-year performance relative to each fund’s benchmark (includes only those funds with a complete return history for the period). As shown, the top quartile comprises 284 funds. The right box shows how these top-quartile funds performed relative to their benchmarks in the subsequent five-year period. The arrows indicate the movement of these top funds across quartiles.
Only 19% of the top-quartile funds repeated their top performance in the subsequent five-year period. Forty-two percent of the funds dropped to the second, third, or bottom quartiles. More significantly, 39% of the original top-quartile funds did not survive the entire period. When combined with the bottom half of the subsequent five year performers, a grand total of 68% of the previous top performing funds would have disappointed those investors who believed they were investing in the best managed funds.
What this means is that the majority of these “top” managers, who were perceived as the most skilled in the US equity market, showed no ability as a group to repeat their top-quartile performance. Indeed, almost four out of ten funds did not survive (which usually means they were closed or merged with other funds due to poor performance), with almost 30% of survivors posting subpar performance.
The lesson: choosing actively managed equity funds according to past success does not guarantee an equally successful investment outcome in the future.
Bond Picking Skill?
This next chart shows the subsequent five-year performance of the top-quartile of actively managed US bond funds. The stacked graph at left begins with the 148 funds in the top 25% of performance (relative to their respective benchmarks). The arrows show how these top performers fared in terms of quartile rankings in the subsequent five-year period.
Similar to the equity fund analysis, a low percentage (23%) of the top-quartile bond funds repeated their high performance relative to their particular benchmark, while 35% failed to survive the period. When combined with the 17% in the bottom half, over half of the previous periods best performing funds winding up among the worst performers over the next five years.
Although investors may attribute a manager’s top ranking to superior knowledge and skill, these stock and bond fund illustrations suggest that relative performance among actively managed funds is mostly random, and investors cannot use past returns to predict future winners.