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Does Past Investment Performance Matter?

In the investment industry, it’s common for investors to use the ‘Past Performance of a Fund or Manager’ as one of the main, and sometimes only, determinant when purchasing a specific fund or hiring a specific manager. Many people believe that a good fund or manager who performed better than average in the past, must be able to do so in the future. Unfortunately, in investing it just doesn’t work that way.

The theory of past performance predicting future performance comes from our life experience. When an established brand, for example, a quality car manufacturer (BMW or Mercedes or similar), has made quality cars in the past and established quality as a core part of who they are, we expect them to continue to make quality cars in the future. We purchase such products because they’ve demonstrated quality in the past and we expect that to continue.

But investing is different. Due to many biases that we have, as well as creative marketing efforts by fund companies, people tend to focus on the most recent results of a fund/manager while not putting much value on the longer-term performance of that same fund/manager. By focusing on short-term performance, we’re not looking at the big picture, and over the long-run, we may be disappointed by the ‘expected high quality fund/manager’ that we just bought.

The S&P/Dow Jones Indices, creator of the well-known S&P Indices (such as the S&P 500), publishes a semi-annual report that studies ‘performance persistence’. This report looks for funds that were top performers in the past and compares it to their continued future performance. The purpose of this study is to answer the question: Will a top performing fund continue to be a top fund? The latest research shows that there isn’t really any persistence of performance on active mutual funds. Over the 5 year time-frame (2012-2016), which is still considered short-term in nature, almost none of the top performing funds remained in the top quartile throughout. More specifically, only 2 large-cap funds remained in the top 25%, and NO mid-cap or small-cap funds (a total of 2656 funds!) remained in the top 25% over the five years of the study. This is even less than what could have occurred by pure chance or luck. Research shows that when looking at past performance over even longer periods of time, it is even more unlikely that past performance will predict future performance.

Performance Persistence of Domestic Equity Funds Over Five Consecutive 12-Month Periods

Source: S&P Dow Jones Indices LLC

All of this data shows that investment performance, unlike other things in life, cannot be held to the standard of high continuing quality. In investing, many things can be responsible for recent, so-called ‘high quality’ performance, including luck and timing. More often, that successful performance doesn’t persist and many clients get disappointed and change course. Unfortunately, many investors typically follow the same faulty process, again looking for the previous year’s best performer.

Instead of making this same mistake, clients should look for real ‘performance determinants’ such as global and asset class diversification, low costs, and emotionless manager decision-making, when looking for performance over the long-term. Only then will investing really work and provide the high-quality returns that most clients are looking for.

Sincerely,

Patrick Volk
Lead Advisor, InvestEd.

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