The Persistence Scorecard

Posted On January 3, 2019 By Scott Stratton, CFP(R), CFA In Portfolio Management /  

As investors begin reviewing their year-end 2018 statements for their 401(k) and other accounts, I know many will want to change funds after a disappointing year. What do investors do? If they have 15 funds available in their plan, they will often sell out of their lagging fund and put money into whichever funds are performing best.

It seems rational enough to believe that a fund manager who is doing well might have above average skills, work harder, or have a better team than other fund managers. That’s why many investors switch funds – in the assumption that an excellent track record is evidence that strong performance will continue. 

You should care about your funds and their managers. But the reality is that switching funds for better performance is not a slam dunk. In December, Standard and Poor’s released their semi-annual Persistence Scorecard. I hope you will read this report. It may change how you invest, how you select funds, and the reasons why you would switch from one fund to another.

In the Scorecard, S&P analyzes returns of over 2,000 US mutual funds, to determine whether high performing funds continue to have strong performance. They evaluate funds by quartile, with data through September 30, 2018. The top 25% of funds would be called first quartile and the worst 25% of funds would be the fourth quartile.

When you buy a fund in the top quartile, what is the likelihood that it will stay a top performer? Let’s go back to September 2016 and track the 550 domestic equity funds that were in the top 25% for the preceding one-year period. Only 21.09% of the top quartile funds stayed in the top quartile in the next year, ending September 2017. And only 7.09% of the 2016 top quartile funds managed to stay in the top quartile for both 2017 and 2018. Of the funds in the top 25% in 2016, only one in thirteen would stay in the top quarter for the next two years.

When you buy this year’s top funds, it is very unlikely that those funds will continue to be the best performers in the subsequent years. Even though we have all heard that “past performance is no guarantee of future results”, everyone still wants to buy the 5-Star fund, even though all that rating tells us is the fund’s most recent performance!

Perhaps you knew better than to put much weight on one year performance. Still, wouldn’t a good manager be able to create a nice long-term track record? The Scorecard also looks at three and five-year returns.

Let’s consider the five-year data:

We will go back to September 2013 and track the 497 funds which were in the top quartile for five-year performance. How did they do over they following five years, through September 2018?

Only 27.16% would stay in the top quartile for another five years. 21.73% would fall to the second quartile, 20.32% would fall to the third quartile, and 21.13% would end up in the bottom quartile. Additionally, 9.46% of the top funds in 2013 would not even exist five years later. Fund companies merge or liquidate their worst performing funds to make their track records disappear. That’s right, when you go on Morningstar and look up funds, what you see is the result of Survivorship Bias. The record has been cleansed of the worst offenders and you only see the survivors. Thankfully, S&P keeps all data and includes deleted funds in its study.

To me this is another reason to use index funds rather than active managers. There is little evidence that when you pick a top performing manager that he or she will persist as a top performer. In fact, there is about only a one-in-four chance a top fund will remain in the top quartile. That’s pretty much a roll of the dice. Switching from one active manager who is underperforming to another active manager who was recently outperforming is very unlikely to be a successful strategy.

Instead of focusing on manager selection and risk chasing performance, we take a more structured approach:

1. Start with the overall asset allocation. Your weighting of stocks and bonds (60/40, 70/30, 50/50, etc.) is the largest determinant of your portfolio risk and return in the long run.

2. Determine how much you want in each category, such as US Large Cap, US Small Cap, US Value, International, Emerging Markets, etc. We base this on correlation, risk and return profiles, and diversification benefits. Then, we adjust the weightings towards categories which we feel are presently undervalued relative to the others.

3. Choose funds which closely reflect those categories. If you are buying a mid-cap fund, it should act like a mid-cap fund. 

4. Expenses matter. According to research from Morningstar: “the expense ratio is the most proven predictor of future fund returns.” We prefer funds with low expenses so you can keep more of the performance you are buying.

5. While we could use actively managed funds, we like the track record of index ETFs, along with their low cost, tax efficiency, and transparency. They are great building blocks for a portfolio.

Being diversified means owning a broad basket of holdings. This can be frustrating sometimes, wondering why you own A instead of B, when A is down this year and B is up. But putting all your money into whichever category or fund is doing best at any one point in time is not an effective strategy. That’s not just my opinion – look at the data from Standard and Poor’s Persistence Scorecard and I think you will reach the same conclusion. Bet on the market, not the manager.

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Three Studies for Smart Investors

Posted On June 1, 2014 By Admin In Portfolio Management /  

Over the last several years, my investment approach has become more systematic and disciplined.  In place of stock picking or manager selection, I believe clients are better served by a focus on strategic asset allocation. Today, we offer investors a series of 5 portfolio models, using ETFs (Exchange Traded Funds) and mutual funds. This approach offers a number of benefits, including diversification, low cost, transparency, and tax efficiency.

This evolution in approach occurred gradually as a result of continued research, personal experience, and pursuing the goal of a consistent client experience.  In my previous position, I managed $375 million in client portfolios, performing investment research, designing asset allocation models, rebalancing and implementing trades.  I am grateful for having this experience and want to share the reasons why I believe investors are best served by the approach we’re using today.

My investment approach is underpinned by three academic studies.  These studies look at long-term investment performance, are updated annually, and offer great insight into what is actually working or not working for investors. As an analyst, I am very interested in what data tells us, and how this may differ from what we think will work or what should work in theory.  But even if you aren’t a numbers geek like me, these studies instruct us about investor behavior and where you should focus your efforts and energy.  I’m going to give a very brief summary of each study and include a link if you’d like to read more.

Published semi-annually, SPIVA looks at all actively managed mutual funds and calculates how many active managers outperform their benchmarks. The long-term results are consistently disappointing.  As of December 31, 2013, 72.72% of all large cap funds lagged the S&P 500 Index over the previous five years.

Sometimes, I hear that Small Cap or Emerging Market funds are better suited for active management because they invest in smaller, less efficient markets.  This sounds plausible, but the numbers do not confirm this.  The data from SPIVA shows that 66.77% of small cap funds lagged their benchmark and 80.00% (!) of Emerging Market funds under performed over the past five years.

The lesson from SPIVA is that using an index fund or ETF to track a benchmark is a sensible long-term approach.  Indexing may not be exciting or produce the best performance in any given year, but it has produced good results over time and reduces the risk that we select the wrong fund or manager.  Our approach is to use Index funds as a core component to our portfolio models.

The other conclusion I draw from SPIVA is that if large mutual fund companies, with hundreds of analysts, cannot consistently beat the benchmark, it would be foolish to think that a lone financial advisor picking individual stocks could do better.

After looking at SPIVA, it may occur to investors that 20-35% of funds actually did beat their benchmarks over 5 years.  Why not just pick those funds?  Why settle for average when you can be in a top-performing fund?

The S&P Persistence Scorecard looks at mutual funds over the past 10 years.  At the 5-year mark, the scorecard ranks funds in quartiles by performance and looks at how the funds’ returns were in the subsequent five years. This tells us if a top performing fund is likely to remain a leader.

Looking at all US Equity funds, we start with the funds which were in the top quartile in September 2008. Below is breakdown of how those top quartile funds ranked in the subsequent five years, through September 30, 2013:
1st Quartile:  22.43%
2nd Quartile  27.92%
3rd Quartile:  20.53%
4th Quartile:  16.71%
Merged/Liquidated:  12.41%

Of the funds in the 1st Quartile in 2008, only 22% remained in the top category in the following 5 years.  29%, however, fell to the bottom quartile or were merged or liquidated in the following 5 years.  So, if your method is to go to Morningstar and find the best performing fund, please be warned,past performance is no guarantee of future results.  In fact, the Persistence Scorecard tells us that not only is past performance not a guarantee, it isn’t even a good indicator of future results.  The results above aren’t much different than a random chance of 1 in 4 (25%).  Albeit disappointing and counter-intuitive, the reality is that past performance offers virtually no predictive information.

Now in its 20th year, QAIB compares mutual fund returns to investor returns.  The reason why they differ is because of the timing of investors’ contributions and withdrawals from mutual funds.  For example, people may think that it is safer to invest when the market is doing well and they buy at a high.  Or, investors chase last year’s hot sector and sell out of a fund that is at a low and just about to turn around.  Investor decisions are consistently so poor that we can actually measure the gap between the average investor’s return and the benchmark.  You might want to sit down for this one – over the 20 year period through 2013, the S&P 500 Index returned 9.22% annually, but the average investor return from equity mutual funds was only 5.02%.  The behavior gap cost investors 4.20% a year over two decades.
We can draw three very important conclusions from QAIB:
– We should avoid trying to time the market (buy/sell);
– Chasing performance is more likely to hurt returns than improve returns;
– Without a disciplined approach, including a target asset allocation and monitoring/rebalancing process, what may feel like a good investment decision at the time may ultimately prove to be a poor choice in hindsight.

These three studies are so important that I carry excerpts from the reports with me to discuss with investors. They’re fundamental to my investment approach, and hopefully, their significance can easily be grasped and appreciated by all our clients.

While we’ve focused exclusively on investment philosophy in this post, I would be remiss to not add that the benefits of working with a CFP(R) practitioner are not limited to portfolio management.  A comprehensive financial plan includes many elements, such as savings/debt analysis, risk management, tax strategies, and estate planning.  The investment management component tends to get the greatest attention, but the other elements of a personal financial plan are equally important in creating a foundation for your financial security.

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