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.