Mutual Funds: Don’t Chase Past Performance

This is a pet peeve of mine, and I am seeing it more and more as the dot-com crash of 2001 fades into the distance. As I read various money magazines, I see mutual fund companies taking out full page ads touting their 1-, 3-, and 5-Year average annual returns. How they beat the S&P 500 Index or Lipper average to a pulp. Then, in the fine print below, you will always find these required words: ‘Past performance does not guarantee future results’. You know why? Because it’s true.

Sure, I could make up a MyMoneyBlog Alpha, Beta, Kappa, and Zeta Mutual Fund with different holdings, and one of them will probably beat the market too just by the odds. Heck, I have personally beaten the S&P 500 since I started trading stocks five years ago, even neglecting dividends. Does that mean you should trust me with your money? If so, please send it to… Historically, just because a mutual fund has beaten the averages for a recent time period, it does not mean it will in the future. In fact, due to mean reversion it is likely to do even worse than average.

I am not going to go into a whole mutual fund investing lecture, because there are plenty of good books for that. I just wanted to point this out so people will notice it from now on. If you could pick winners based on simply their recent performance, we’d all be rich. The mutual fund marketers are simply playing to human pyschology which expects such trends to continue. Research says it doesn’t. If you’re going to buy a mutual fund based on a colorful magazine ad, please let it be an ad for a low-cost index fund!

Comments

  1. good post! don’t touch mutual funds! theyre a money trap.

    for newbie investors, ‘investors business daily’ is a good place to spot fundamentally sound (buy and hold) kinds of stocks.

  2. Well, I’m not exactly a proponent for beginning investors to go out buying individuals stocks either, but that’s another post ;)

  3. Past returns MAY be indicative of future performance over the long run if the mutual fund has a good quantititave methodology AND the fund director sticks to that method it MAY be indicative of future performance. I recommend reading O’Shuaghnessy’s ‘What Works on Wall Street’. It’s also why index funds beat managed funds over the long run. They have a consistent investment method, by default, and don’t waver like managed fund managers by using the flavor of the day investement approach.

  4. A lot of times it’s the success of the fund which causes it to underperform in following years. The reason for this is that the fund manager simply cannot effectively deploy the millions in new capital they receive as the sheep rush to jump on the bandwagon.

    I only invest in mutual funds for our 401k accounts. (because I have no choice) I tend to prefer managed funds with good track records. I also check out the holdings of the fund to make sure they invest in companies I would consider owning. I also take a macro view of the funds we’re in and periodically adjust for trends I think are going to happen. (i.e. I moved some out of small cap funds and into larger caps late last year)

  5. Newbie investors should not just run out and buy individual stocks if they don’t know what they are doing. Mutual funds have their purpose and their role in a portfolio, don’t incorrectly classify them ALL as money traps.

  6. Where do I send that check? I think I like the Alpha fund. ;-)

  7. Some funds perform better in a bull market (say growth funds), some perform better in a bear market (value funds). If you can follow the trend with mutual funds, you can beat the market at least a bit. We can also play with the allocation (large vs mid vs small vs foreign vs bonds), too.

  8. Yes, but…is momentum investing entirely unreasonable?

    Suppose we took a shorter time period, maybe the past 45 days, and bought the top five (no-load) funds by total return, and sold them only when they dropped out of the top 25% or 35% of all funds in 90-day trailing returns, could that be a reasonable strategy? I don’t have the data to back-test it, but I’d be interested in seeing the numbers from someone who has!

  9. LOL if you have not bet the market from 1999 till now you got big problems. The market low was in 1999. You could have pretty much taken a dart and thrown it at the bussiness page of the paper picked your stocks that way. If the company did not go broke chances are that they are up.

    For example back on Jan 1 2000 dell was $13.25 a share on Jan 1 2006 dell was $30 a share.

    You want me to keep listing stocks? or you get my drift.

    It not hard to make money when everything is going up. The problem is when you are in a bear market if you dont know what you are doing chances are the stocks you pick tend to get wacked the hardest too.

  10. Jonathan,

    Hi there. Great website. I just opened up an HSBC online savings and I wanted to ask about the $3 service charge for bank transfers. How can we get around that?

    Thanks

  11. I subscribe to the mutualfundshow theory .. you pay attention to the managers that generate the performance. If someone has had good performance, a good track record, you have better odds they will continue to do well in the future than someone who doesn’t have a good track record. If a fund switches managers then the past performance goes out the window because it was the manager who got the performance, not the fund itself.

    Its not a silver bullet but i think it increases the odds that the fund will do well.

  12. Clearly some people are better at picking stocks than others. Some mutual fund managers are better than others. But indexing, keeping all costs low, that’s the best strategy rather than chasing a superstar fund or managaer.

  13. I read a research article that looked historically at a strategy of trading into last year’s worst performing fund, versus a strategy of trading into the last year’s best performing fund, both with switches at the end of each year.

    Guess which won over the long term? Picking the worst perform by a margin of around 50%.

  14. Jonathon and everyone else,

    I’m 50 and reached 7 figure N.W. 2 years ago. Here’s my first post on this blog, and it’s one based on a LOT of experience.

    I bought my first mutual fund 1n 1986, that’s a whole story itself. Anyway, there is one way to get rich….and that is slowly. Vanguard’s STAR fund is what I’m going to recommend to my son when he graduates from college to start his investment program. The key to getting rich is to pick an Asset Allocation, and stick with it. Ride out all the hype, ups and downs etc.

    This fund has Three dimensional diversification. 1.) It is diversified into different asset classes.2.) Within each asset class, it is further diversified ( i.e it has value and growth in International stocks; is has 2 U.S. value stock funds; it has 3 different types of bond funds, etc. etc.) and of course, each individual fund is diversified itself.

    You won’t ever win big, but you will never lose big either. and that’s the other key…. don’t set yourself up to lose big.

    All for now

  15. Allen wang says:

    Hi Gary,

    Could you tell me the Vanguard fund code you invested? I just checked the fund code (VAAPX), but it does not have three dimensional diversification in its profile as you described.

    Thanks!

    Allen

  16. The Vanguard STAR Fund has the symbol VGSTX. It is a fund of funds and does hold both bond and stock fund. It includes some of Vanguard’s actively managed funds, like Windsor.

  17. Allen,

    No, it sounds like you had the wrong fund. Jonathon has the correct code I believe. They won’t use the phrase “three dimensional Diversification” in their literature. It’s a term I just came across a few months ago, and it fits the situation.

    I’ve owned this fund for 14 years now ( actually have it in 2 separate accounts), and have held another interesting fund T.Rowe Price Capital Appreciation for 14 years ( two separate accounts for that one also).

    Jonathon, you are correct and right on the money. It also holds Windsor II fund ( this is another “value” fund and shows the concept of “Three Dimensional Diversification” i.e it has 2 value funds, each of which may take a somewhat different approach ). Also has a couple of different U.S. growth stock funds, I think I forgot to mention that in the first post.

    Low costs too.

  18. Hi Jonathan,
    I read the recent article in businessweek and am checking out your site today – it is very interesting. I work in the investment management field and want to quickly explain why I disagree with you on this point (re: mutual funds/managers and your reversion to the mean argument). While early (and well publicized) research on this matter supported the strong form of the efficient market hypothesis, more recent (and thorough) research actually shows that some managers are able to consistently outperform the market over long periods of time. The key to investing in a mutual fund is finding the managers that have demonstrated outperformance over long (i.e. 10-year) periods and then stick with them – and not be quick to judge performance over some short, arbitrary period (i.e. one quarter or one year). For example, many great value investors had a tough time during the two or three years of the tech bubble, but more than made up for it prior to it and since (one example: Fidelity’s Joel Tillinghast’s returns for the past 10 and 15 years are astounding, but his relative returns during the late 90s were not particularly good). The compounding benefits of sticking with a manager that outperforms over a long period are remarkable – I will agree that individual investors tend to get themselves in trouble by trying to catch the latest high flier. Find a good manager – or catch a young one that has worked under a great manager – and stick with him/her.

  19. CFA – Thanks for your comments! Do you have a link or an article name for this newer research? I’d be interested to read it. You’d think the mutual fund companies would be all over it and publicizing it themselves.

    I’m sure one could argue that of course some managers will beat the market over long periods of time, statistically that is a given. I’m not saying you’re wrong, just throwing that out there.

  20. I will have to go back and check my old notes/textbooks to get the specific papers I read (it’s been a couple of years, and a couple of office moves ago), but this link provides a balanced, easy-to-read summary of some of the studies that have been done, and gives you a sense for how many different conclusions have been drawn on this subject (I just skimmed it):

    http://cisdm.som.umass.edu/research/pdffiles/performancepersistence.pdf

    Other studies that you could check out include Grinblatt & Titman (1992) and Elton, Gruber & Blake’s “The Persistence of Risk-Adjusted Mutual Fund Performance”

    I don’t know anything about fund marketing, but I suspect that there are two big reasons fund companies don’t try to exploit the favorable research on this subject – one, about 99% of the public wouldn’t be able to follow it (very few people know what a t-statistic is, never mind advanced econometric methods) and, two, you really can’t draw any firm conclusions from either side. That is to say, all of these studies (i.e. on both sides) are subject to criticism – be it how one defines “persistence” to sample size to the time period being investigated to any number of statistical issues. The takeaway from the most compelling research I have read on this subject basically says that there is evidence to conclude that the top quartile and bottom quartile of fund managers show persistence and the middle 50 basically bounce around. Said another way, the very good guys outperform over the long haul, the very bad guys (that stay in business) underperform consistently over the long haul, and the majority (i.e. middle 50) have their share of up years and down years and basically earn back their fees. My suggestion is to find managers in the top quartile (Miller, Danoff, Tillinghast, or managers who have worked closely with managers like that – or successful team-managed funds like Dodge&Cox or American) and stick with them over 10+ year period and reap the rewards of compounded outperformance.
    Also, I would argue that it is not a statistical “given” that some managers outperform over long periods – it is a statistical “possibility”, but if you are suggesting that returns are essential random (i.e. that persistence does not exist, and the probability of any given year being a year of outperformance or underperformance is equal), than it is the same possibility as flipping a coin 15 times and the coin coming up heads each time – which would happen ~0.00305% of the time. Just something to think about.

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