The Perils Of Picking Past Winners

Past performance influences mutual fund selection in the worst way. Money flows into funds that have been winning. Yet, more often than not, these funds are destined to tumble in ranking or go out of business. Investors who consider winning past performance to be a good indication of success in the future are playing with fire.

Morningstar has been tracking and rating mutual fund performance for over two decades. A fund’s Overall Morningstar Rating is based on its average Risk-Adjusted Return over 3-, 5-, and 10-year periods. Only 10% of funds receive the coveted Morningstar 5-star rating.

Investors flock to 5-star funds, according to the Morningstar 2012: Annual Global Flows Report. Net new assets into the top category overwhelmed the other four categories. Figure 1 highlights the global cash flows into funds based on their star ratings during 2012.

Figure 1: Global Mutual Fund Cash Flow Based on Morningstar Ratings


Source: Morningstar 2012: Annual Global Flows Report, March 2013

Are investors setting themselves up for a fall by chasing top funds? They may well be according to the newly released S&P Persistence Scorecard (July 2013). Published twice per year, the S&P Persistence Scorecard tracks the consistency of top performing mutual funds over consecutive 3- and 5-year periods to measure their persistence of return.

A detailed analysis of the data shows that winning funds have a low probability for outperforming over the next period. The odds are even less than one would expect by randomness alone.

Figure 2 shows how 483 Top Quartile – All Domestic US Equity Funds ending in March 2010 fared over the next consecutive 3-year period ending in March 2013. The categories are divided into four quartiles from best (1st Quartile) to worst (4th Quartile) and a 5th category for funds that closed or merged or liquidate over the period. A random return would be 25% in each of the four quartiles with no mergers or liquidations.

Figure 2: Top Quartile, All Domestic US Equity Funds, consecutive 3-Year period ending March 2013


Source: S&P Persistence Scorecard, Exhibit 3, page 3.

Only 23.81% of the top quartile US Equity Funds ending in March 2010 stayed in the top category over the next 3-years ending in March 2013. More funds ended in the bottom 4th quartile than in the top, and 9.32% of the winning funds didn’t survive. They were either merged with another fund or liquidated.

Being a contrarian doesn’t work either. Figure 3 shows how 483 bottom quartile All Domestic US Equity Funds ending in March 2010 performed over the next consecutive 3-year period ending in March 2013. Again, a random return would be 25% in each of the four quartiles with no mergers or liquidations.

Figure 3: Bottom Quartile, All Domestic US Equity Funds, consecutive 3-Year period ending March 2013

Source: S&P Persistence Scorecard, Exhibit 3, page 3.

The bottom performing funds experienced many more mergers and liquidations than the top quartile US Equity Funds. However, it’s worth noting these previous losing funds had a surprisingly high number of funds moving up into the 1st and 2nd quartiles. Overall, 39.54% of the bottom dwellers moved into the top half versus 44.72 percent of the top quartile funds staying in the top half. Not a bad showing for the worst performing funds from the previous 3-year period.

The new S&P Persistence Scorecard has a wealth of data on mutual fund performance persistence. The study divides funds by large-, mid-, small- and multi-cap style for easy comparison. It is also divided into 3- and 5-year periods for greater depth of analysis.

You’ll find a few bright spots in the data that would suggest some favorable treatment of past performance in fund selection, although I’ve found from reading these reports over the years that those bright spots fade quickly. Persistence may seem to matter at times, but the illusion doesn’t last.