Swedroe: Avoid High Ranked Funds

December 01, 2017

To date, an overwhelming body of academic research (including on active share as a predictor) has demonstrated that a mutual fund’s past performance not only fails to guarantee its future performance (as the required SEC disclaimer states), but has almost no value whatsoever as a predictor—with the exception that poor performance, combined with high expenses, typically predicts future poor performance.

5 Stars & Persistence

A good example showing the lack of ability to identify in advance which of the very few active funds will go on to outperform in the future comes from the 2010 Vanguard study “Mutual Fund Ratings and Future Performance.”

The authors, Christopher Philips and Francis Kinniry Jr., examined excess returns over the three-year period following a given Morningstar rating, finding that “higher ratings in no way ensured that an investor would increase his or her odds of outperforming a style benchmark in subsequent years.”

In fact, they write that “5-star funds showed the lowest probability of maintaining their rating, confirming that sustainable outperformance is difficult. This means that investors who focus on investing only in highly rated funds may find themselves continuously buying and selling funds as ratings change. Such turnover could lead to higher costs and lower returns as investors are continuously chasing yesterday’s winner.”

The academic research has shown that a lack of persistence in outperformance beyond the randomly expected exists not only among mutual funds, but also among hedge funds and even pension plans—despite their use of high-powered consultants who advise them on identifying the future winners.

Despite this lack of persistence in outperformance beyond the randomly expected, and the failure of ratings and other systems to identify future winners, the research also shows that investors continue to chase past results, be it absolute returns or published performance rankings.

For example, the study “Morningstar Ratings and Mutual Fund Performance” from Christopher Blake and Matthew Morey found that an amazing 97% of fund inflows went into four- and five-star funds, while even three-star funds experienced outflows.

Investors are ignoring the fact that even Morningstar has admitted its star ratings do not have predictive value, and that simply ranking by expenses has superior predictive value.

Kings With Short Reigns

Ron Kaniel and Robert Parham contribute to the literature on investor behavior with their study “WSJ Category Kings—The Impact of Media Attention on Consumer and Mutual Fund Investment Decisions,” which appears in the February 2017 issue of the Journal of Financial Economics.

The authors note that The Wall Street Journal has prominently published the 10 top-performing mutual funds based on prior 12-month returns (not risk-adjusted), ranked within various commonly used investment style categories, every quarter since 1994.

They continue: “The top 10 ranking lists are part of an independent section, ‘Investing in funds—A quarterly analysis,’ and have an eye-catching heading, ‘Category Kings.’”

Kaniel and Parham examined how the publication of the rankings impacted investor cash flows (in other words, they explored if investors believe recent, 12-month performance predicts future performance despite all the published literature showing otherwise) as well as whether it impacted fund manager behavior. Their study covered the period 2000 through 2012.

Following is a summary of their findings:

 

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