Tuesday, June 29, 2010

Past Performance Does Not Matter

Yes, it sounds like something from the mouths of market efficiency fanboys. Yes, it’s something one would expect in this space, given this blog’s recent proclivity to bash the art of active fund management and the oft-maligned school of technical analysis.

We’re all guilty of it, at one time or another: using what happened in the past to predict, or at least have some idea of, what will happen in the future. In school we learned how to use historical sales to forecast a firm’s future demand, how to use past data to assign probabilities to events that can happen in the future, and how technical analysis is based on the premise that historical stock prices produce patterns that are bound to repeat in the future.

In the real world, we are confident that we’ll earn big from investing in the stock market because we know more than a handful of people who’ve done it before. Also, we base our investment decisions on how well a particular fund has performed in recent years, despite reading this qualification in the fine print of fund reports, something that’s required by law for mutual funds, UITFs, and other similar instruments.

A new study from Standard & Poor’s presents stronger evidence against fund managers who try to lure investors with the implied promise that a strong recent performance will happen again in the future. The study looks at top mutual fund performers over three-and five-year periods, how the funds performed each year in those periods and whether a top-performing fund in one period was able to repeat the same performance in the next period.

The major findings of the study include:
  • Very few funds manage to consistently repeat top half or top quartile performance. Over the five years ending March 2010, only 1.7% of large-cap funds, 2.2% of mid-cap funds, and 4.6% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Random expectations would suggest a rate of 6.25%.
  • Looking at longer term performance, 18.5% of large-cap funds with a top quartile ranking over the five years ending March 2005 maintained a top quartile ranking over the next five years. Only 12.7% of mid-cap funds and 25.0% of small-cap funds maintained a top quartile performance over the same period. Random expectations would suggest a repeat rate of 25%.
It must be said, though, that these results against actively-managed funds like mutual funds and UITFs greatly favor S&P since it’s in the business of selling passive index funds. But still, the numbers present very strong evidence that, indeed, it would be foolish to base investment decisions solely on past performance.
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