The question on everyone’s mind is: are you able to pick funds that will beat the market in the next year or two and make a profit?
Short answer? No.
As I covered in another video, even though stock prices aren’t necessarily correct, no one can consistently predict the direction in which they’re wrong. Today, we’re going to take a look together on what this means in the world of active fund managers, and why it’s virtually impossible to pick a winning fund ahead of time.
You Can’t Predict the Future
As investors, we’re always trying to find the best fund managers out there that will give us the most bang for our buck. This is true for large pension funds, endowments and individuals like you and me. Typically, we start our search by looking at which fund managers performed best in the last 5 or 10 years. By doing this we assume that we’re separating the wheat from the chaff.
The problem is that this doesn’t work! This presumes that the fund managers that beat the market in the past will continue to beat it in the future. But when we take a look at the data, this isn’t the case. To start with, there’s a survivorship problem. Of all the funds available to choose from today, only about half of them will still be around in 15 years. I’ve linked a great paper about mutual fund survivorship by finance researcher, Mark Carhart, on the blog post below1 if you’d like to know more.
This is still true even if you only pick from the top performers! It turns out that when you rank funds based on their past 3 or 5-year performance, then analyse the performance of the top 25%, over the next 3 years, what you’ll find is that they don’t perform any better than the funds in any of the lower quartiles. This means that past performances don’t predict how well a fund will do in the future.
And if you’re thinking that the big pensions and endowment funds get better results thanks to their high-priced consultants guiding them, then guess again. Sunil Wahal, a professor at Arizona State University conducted a study of thousands of large pension and endowment funds hiring and firing decisions2 when it came to fund managers. What he found is that managers that were typically hired following a strong 3-year performance didn’t perform any better than the market in the following years. To make matters worse, if the big pensions and endowment funds had stayed with the fund managers they fired, they would have performed better than the newly hired fund managers!
Buyer Beware
So, the next time you see the disclaimer at the bottom of any fund performance report that says: “Past performance is no guarantee of future results.” Don’t ignore it!!!
If you’re set on doing it on your own, here are Dan Bortolotti’s model portfolios.
Do you think you can beat the market? Comment below and let me know what your strategies are when picking funds for your portfolio.
1 Carhart, Mark M., Mutual Fund Survivorship (May 15, 1997). USC working paper 97-1. Available at SSRN: https://ssrn.com/abstract=36091 or http://dx.doi.org/10.2139/ssrn.36091
2 Goyal, Amit and Wahal, Sunil, The Selection and Termination of Investment Managers by Plan Sponsors (November 2004). EFA 2005 Moscow Meetings Paper. Available at SSRN: https://ssrn.com/abstract=675970