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:
- Funds that achieve the category king (top 10) ranking experience a 31% increase in capital flows during the post-publication quarter, indicating consumers strongly react to media attention directed at these funds.
- Interestingly, while year-to-date rankings are published monthly, though less prominently, there is no significant impact in the flows to these category kings during the year. Flows only increase after the full-year report is made and is prominently displayed and advertised. Both subsequent fund advertising and subsequent media mentions play a role in increasing flows.
- Investors change their attitude toward a category king’s entire brand/complex, and a sizable spill-over effect exists. Capital flows into other funds in the complex increase 1.8 percentage points in the subsequent quarter, consistent with an impact of media attention and visibility on brand name recognition at the complex level, and less consistent with an information channel.
- Small, young funds from small complexes, which are ex-ante less visible, enjoy a higher “bang for the buck” from being published, consistent with the importance of visibility.
Kaniel and Parham note: “The existence of a media effect on consumer financial decision making implies that fund managers’ payoffs resemble a call option due to the implicit asymmetric incentives induced by the extra flows.”
In addition, consistent with theoretical predictions, they found that funds ranked near the cutoff at the beginning of the previous ranking month—and only those funds—diverged from the herd by increasing tracking-error volatility relative to their category in an apparent attempt to make the list.
In other words, fund managers are well aware of the trade-offs induced by this risk, and so take on more of it, increasing tracking error volatility and, thus, their likelihood of making it into the top 10 and becoming a WSJ category king.
Kaniel and Parham found fund rankings and subsequent media attention affects flows even when it does not contribute new information, as long as the publicity appears sufficiently prominently.
This occurs despite the fact that such rankings have been found to have no value in terms of predicting future results—investors ignore the evidence as well as the SEC-required disclaimer on past performance. Importantly, they also found that fund managers increase their risk-taking near the end of the year to increase their chances of being crowned a category king.
Given all the published research on the inability to identify future outperformers, it’s hard to explain why retail investors chase performance. While institutional investors are rapidly approaching the point where they have more assets managed in low-cost, passively managed funds (such as index funds) than in actively managed ones, individual investors still hold only about 15% of their assets in passively managed vehicles.
It seems unlikely they are still ignorant of the data. The more likely explanation, perhaps, is that while facts are stubborn things, the human mind is far more stubborn—the ability to let go of long-held beliefs is an uncommon trait.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.