Swedroe: Chasing Active Outperformance Ratings

October 25, 2017

The holy grail for mutual fund investors is the ability to identify in advance which of the very few active mutual funds will outperform in the future.

To date, an overwhelming body of academic research has demonstrated that past performance not only fails to guarantee 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 predicts future poor performance.

The research has shown that not only is there a lack of persistence beyond the randomly expected 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.

The evidence on plan sponsor performance is so strong that a 2008 study by Amit Goyal and Sunil Wahal, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” found that if plan sponsors had remained with the investment managers they regularly fired, their returns would have been larger than those actually delivered by the newly hired managers.

The bottom line is that past performance’s only value seems to be in showing that poor performance tends to persist, with the likely explanation being high expenses.

Superstar Or Superdud?

Jerry Parwada and Eric K.M. Tan contribute to the literature on the predictive value of past performance through their February 2016 study, updated in October 2017, “Superstar Fund Managers: Talent Revelation or Just Glamor?

The authors examined the performance of funds managed by the winners of Morningstar’s coveted Fund Manager of the Year (FMOY) award. Morningstar selects its FMOY winners based on an expectation of future alpha.

Here is how Morningstar presented its 2016 winners: “To be nominated for Fund Manager of the Year, the manager’s mutual fund must be among the 1,200 that receive Morningstar Analyst Ratings and earn a rating of Gold, Silver, or Bronze. The medal rating indicates that our analysts believe a fund will outperform its category peers and/or benchmark on a risk-adjusted basis over the long haul. Looking at their individual coverage lists, analysts nominate Morningstar Medalist funds that have strong recent and long-term risk-adjusted returns, excellent stewardship practices, and broad shareholder bases. Our asset-class teams whittle down the list to a group of finalists. Then the entire analyst team meets to debate the merits of the finalists in each category, and, following those discussions, analysts vote to determine the winners.”

Flows Chase Ratings

It has already been established in the literature that investors value Morningstar’s ratings, as fund flows tend to follow them. For example, the study “Morningstar Ratings and Mutual Fund Performance,” by 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.

Parwada and Tan examined not only the effect of mutual fund managers’ superstar status (which comes with being named FMOY) on money flows, but also on their risk-taking behavior. Their study covered FMOY winners over the period 1995 through 2012 and compared their performance to the performance of the other finalist managers. Following is a summary of their findings:

  • They confirmed that investors respond positively to mutual fund managers who win a prominent fund-manager-of-the-year award based on proven long-term record. FMOY winners garnered 21% more assets over the 12-month period following the award announcements.
  • Award-winning managers generate positive risk-adjusted performance in the very short term. FMOY winners generated outperformance of 1.6% for the three-month period following award announcements using the Carhart four-factor (beta, size, value and momentum) model. However, that outperformance disappeared when measured during the subsequent six-, nine-, 12-, 24- and 36-month periods. The results were statistically significant at the 1% level of confidence.
  • Award-winning managers do not take on increased risks or trade more actively as implied by attention-induced incentives. There was no evidence of managers becoming overconfident (which could negatively impact performance) after receiving the award.


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