When a friend or a broker recommends an actively managed mutual fund to you, it almost always sports a good track record. The fund’s returns probably exceed its benchmark, and it ranks favorably against other managers. The charts and figures make the mutual fund look so tempting. Should you take the recommendation and sink your money into the fund? Will the fund persist in generating exemplary performance?
About a month ago Standard & Poor’s issued a report titled, “Does Past Performance Matter? The Persistence Scoreboard.” S&P’s analysis confirmed the work of many scholars and analysts. Very few equity mutual funds are able to maintain their edge. In fact, the news is even worse. The number of consistently excellent managers is even lower than a normal random distribution would suggest. In other words, investors would have done better by flipping a coin. The report’s major conclusion received a fair amount of attention in the financial press. However, there’s more good information in S&P’s report that is worth exploring.
I want to discuss four desirable and elusive characteristics of mutual funds. I’ll start with a brief summary of S&P’s conclusions on persistency. Then I’ll move on to examine reversion, stylistic consistency and survival. Reversion is the idea that a mutual fund will regress to its long-term average. Some investors will hold on to a poorly performing mutual fund because they believe it will ultimately get its turn in the sun and perform in the top quartile. Stylistic consistency means that a mutual fund will remain true to its mandate. If the fund is a mid-cap specialist, it will remain that way. Survival implies that the fund will exist in the long run. As you’ll see, actively managed mutual funds tend to dole out more disappointment than reward on all these measures.
Beware of stellar performers
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First, the bad news on persistence. Of the 703 mutual funds in the top quartile in March 2011, only 4.7 percent managed to stay in the top quartile over three consecutive 12-month periods. Amazingly, not one mid-cap manager in S&P’s universe managed the feat. According to S&P, a mere 2.4 percent of large cap managers, 3.2 percent of mid-cap managers, and 4.7 percent of small cap managers were able to stay in the top half of their respective universes over five consecutive 12-month periods. Flipping a coin would suggest that 6.25 percent of the mutual funds should be able to achieve that result.
Here’s one last dismal statistic on persistence: Of the 558 top quartile equity mutual funds in March 2009, only 0.18 percent remained there five years later. By the way, 0.18 percent means that only 1 out of 558 funds remained in the top quartile.
Perhaps you should be a contrarian and rely on reversion. Instead of investing in the stellar performers you should look toward the third or fourth quartile for your mutual fund selections. May be those relatively poor performers have just run into a patch of bad luck. According to S&P’s data, their performance doesn’t rebound in any meaningful way. Lagging mutual funds are about as likely to stay in the bottom quartile as they are to jump into the top quartile. While there are examples of funds going from last to first, there are just as many funds that remain mired in the basement.
In trying to create a clean database for their analysis, S&P had to make sure mutual funds remained stylistically consistent and didn’t merge or liquidate. You wouldn’t be able to draw any meaningful lessons about persistence if mid-cap managers were allowed to morph into large cap managers. Moreover, you’d make the comparisons all too easy for surviving managers if merged or liquidated managers remained in the database. Making these adjustments provides us with some interesting additional insights.
If you hire an active money manager, you want him to be consistent. While large cap and small cap managers tend to stick to their knitting, mid-cap and multi-cap managers appear to have a problem staying true to their respective mandates. For example, among top quartile midcap managers, 49.3 percent changed their style over a five-year period. In other words, you only had about a 50-50 chance that a top-notch mid-cap manager would be managing in a mid-cap style after five years. According to S&P’s data, there was only a 1 in 3 chance that a top quartile multi-cap manager would remain on task. In other words, the lack of persistence isn’t the only thing you have to worry about. A significant proportion of managers seem to drift over time.
Mergers and performance
While top-quartile managers don’t tend to persist in delivering outstanding performance, they tend to survive. Among the 403 top-quartile equity mutual funds with five-year records, only 12.1 percent liquidated or merged. It isn’t stellar performance that encourages them to stay in business. Because most of us tend to chase past performance, most top-quartile managers continue to attract enough assets to make it worthwhile to keep the fund open to investors even as performance eventually flags. By contrast, 26.4 percent and 35.7 percent of all third- and fourth-quartile mutual funds disappeared over a five-year period. In all likelihood, those funds experienced redemptions, making the funds uninteresting to the managers. Even though you may be a long-term investor, a significant number of mutual funds will force you to find another investment because they’ve decided to shut down.
Mergers are a great ancillary benefit for mutual fund managers: They are a convenient way to make bad track records disappear. In a mutual fund merger, only the surviving fund’s track record remains. As you’d expect, the historic record of the surviving fund is always better than the nonsurviving fund. It doesn’t matter if the nonsurviving fund is substantially larger or older than the surviving one. Unless you are willing to spend hours and hours rummaging through the SEC’s databases, you have no way of knowing the actual performance of a mutual fund with a merger history.
Although S&P’s data is compelling and simply reinforces countless other studies, top performing mutual funds will continue to attract the lion’s share of investor capital. The recommendation of a friend or a broker coupled with the compelling marketing campaigns conducted by mutual fund distributors will overwhelm the evidence. At least it’s good news for the researchers at Standard & Poor’s. They release their persistence studies every six months, and they always show the same results. As long as most of us invest with active mutual fund managers, S&P’s analysts will remain gainfully employed as they crank out one study after another.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/