Benjamin Felix July 28, 2017 Personal Wealth But my advisor has shown me lots of funds that outperform. Are you seeing your investment returns through rose-colored glasses? Most investors are … and it’s often because their advisor has provided them with a skewed view. Besides, colorful past performance doesn’t tell you much about your future prospects anyway. Let’s bring in a little common sense, and put investment performance in proper perspective. A financial advisor will never sit down and show you a list of funds that have performed poorly. That is not likely to lead to a sale. This simple truth leads to a much larger issue that affects the choices that investors make. In 2006, there were 90 Canadian equity mutual funds in Canada. At the end of the decade ending in December, 2016, only 38 of those funds, or 42%, still existed. When funds post poor performance, they stop attracting new assets, and eventually close down. When a fund closes down, its performance history goes with it. This is a big problem for the average investor trying to select an investment. At any given time, it looks like a lot of mutual funds have been doing really well – and they have, you’re just not seeing the ones that have been doing poorly. This is called survivorship bias. You only see the funds that have survived, so the whole picture looks rosier than it should. The problem for investors is that an active manager posting strong performance numbers, even over long periods of time, does nothing to indicate their ability to perform well in the future. In this episode of Common Sense Investing, I’m going to tell you why past performance is one of the worst predictors of future results. When an actively managed fund is able to post strong enough performance to survive, it may be an indication of a truly skilled manager, but it’s far more likely to be luck. Mark Carhart’s 1997 paper On Persistence in Mutual Fund Performance, published in the Journal of Finance, looked at 1,892 U.S. mutual funds between 1962 and 1993. The paper concluded that there was no evidence in the data of skilled or informed mutual fund portfolio managers. In other words, the funds that performed well did so by chance. A 2009 paper by Eugene Fama and Ken French titled Luck vs. Skill in the Cross Section of Mutual Fund Returns similarly found that in a sample of 3,156 U.S. mutual funds between 1984 and 2006, few funds demonstrated sufficient skill to cover their costs. In a real-world example, a fifteen-year sample of U.S. mutual funds ending in December, 2015, shows that winning funds are no more likely to continue winning. Of 2,758 funds that existed at the beginning of 2001, only 541, or 20% of them, outperformed through the end of 2010. The next five years didn’t go well for most of those outperformers. Of the 541 winners, only 200, or 37% went on to outperform through the end of 2015. Could you have picked the skilled managers that outperformed through the whole 15-year period? According to the evidence, your chances are slim. Some funds are able to produce very impressive long-term track records, but that does not make them safe bets for investors. In the 1970s, David Baker managed the 44 Wall Street fund to market beating performance for ten straight years. The following decade, it was the single worst performing fund in its category, dropping significantly while the S&P 500 gained. Even more impressive was the Lindner Large Cap Fund, which beat the S&P 500 for the 11 years ending in 1984. While this market beating performance no doubt attracted attention and assets, the fund spent the following 18 years being decimated by the S&P 500. If 11 years wasn’t enough to weed out the lucky managers, Bill Miller’s Legg Mason Value Trust Fund beat the S&P 500 for the 15 years ending in 2005. It suffered miserably against the index for the next seven years before being taken over by a new manager in 2012. Most impressive of all is the Tiger Fund – a hedge fund formed in 1980. It spent 18 years averaging returns over 30% per year, and its assets had grown to $22 billion by 1998. Over the next two years the fund faltered, losing $10 billion, and closed its doors in 2000. The odds of outperformance are slim, but some active managers do beat the market. The challenge for investors is identifying winning managers before they win, and not before they start to lose. A financial advisor who is motivated to sell a product can easily identify a list of funds with great track records, but there is no evidence to show that those funds will continue to perform well in the future. Join me in my next post as I explore what it takes for someone to call themselves a financial advisor. Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
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