A new study by S.&P. Dow Jones Indices has some fresh and startling answers. The study, "Does Past Performance Matter? The Persistence Scorecard," provides new arguments for investing in passively managed index funds - those that merely try to match market returns, not beat them.
Yet it won't end the debate over active versus passive investing, because it also shows that a small number of active investors do manage to turn in remarkably good streaks for fairly long periods.
The study examined mutual fund performance in recent years. It found that very few funds have been consistently outstanding performers, and it corroborated the adage that past performance doesn't guarantee future returns.
The S.&P. Dow Jones team looked at 2,862 mutual funds that had been operating for at least 12 months as of March 2010. Those funds were all broad, actively managed domestic stock funds. (The study excluded narrowly focused sector funds and leveraged funds that, essentially, used borrowed money to magnify their returns.)
The team selected the 25 percent of funds with the best performance over the 12 months through March 2010. Then the analysts asked how many of those funds - those in the top quarter for the original 12-month period - actually remained in the top quarter for the four succeeding 12-month periods through March 2014.
The answer was a vanishingly small number: Just 0.07 percent of the initial 2,862 funds managed to achieve top-quartile performance for those five successive years. If you do the math, that works out to just two funds. Put another way, 99.93 percent, or 2,860 of the 2,862 funds, failed the test.
Yes, that is right. Unless a fund was in the top quartile of performance for each of the four years, it was considered a failure. The premise of the article is that investors should employ index funds unless they can find active strategies that outperform every year. Talk about setting yourself up for failure! I am aware of a number of investment factors that have generated outperformance over time (momentum, value, low volatility), but I am aware of nothing that outperforms every year.
The returns of those managers who are able to generate outperformance over time is rather lumpy. Consider the performance profile of the best performing managers of the 1990′s as an example:
Cambridge Associates, a money management consulting firm, did a study of the top-performing managers for the decade of the 1990s. In 2000, they could look back and see which managers had returns in the top quartile for the entire decade. Presumably, these top quartile managers are precisely the ones that clients would like to identify and hire. Cambridge found that 98% of those top managers had periods of underperformance extending three years or more. 98% is not a misprint! Even more striking, 68% of the top managers ended up in the bottom quartile for some three-year period and a full 40% of them visited the bottom decile during that ten years. Clearly, there are good and bad periods for every strategy.
Investing is challenging enough without setting yourself up for failure by placing unrealistic expectations on active managers. I have nothing against index funds. We use them in a number of our strategies and I think many investors can benefit from using them as part of their allocation. However, they are not a panacea.
This example is presented for illustrative purposes only and does not represent a past recommendation. A relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value.