Swedroe: Chasing Active Outperformance Ratings

October 25, 2017

Success A Red Flag?

An interesting finding is that winning managers generally manage smaller and younger funds when compared to finalist managers. The average fund size of award winners was less than $200 million in assets under management.

Thus, not many investors were benefiting from the winners’ success. This raises the question: Does success sow the seeds of its own destruction? To answer it, consider Parwada and Tan’s finding regarding short-term outperformance, which is consistent with the findings of prior research.

It’s also consistent with the rational expectations equilibrium argument Jonathan Berk and Jules van Binsbergen present in their paper, “Measuring Skill in the Mutual Fund Industry.”

They write that skill exists among superstar fund managers, and investors recognize this skill and reward the managers with capital inflows. The increased capital arbitrages away outperformance due to diseconomies of scale—success does contain the seeds of future erosion.

However, this isn’t the only possible explanation for the short-term outperformance that Parwada and Tan documented. Before concluding there is skill, we should consider other theories.

‘Persistent Flow’

A second theory is that mutual funds’ short-term predictability is driven by stock return momentum. A third explanation for the positive flow/performance relation is what’s called the “persistent-flow” hypothesis. Research has found that investor flow-related buying pushes up stock prices beyond the effect of stock return momentum, and that fund performance owes more to flow-related trades than to managers’ skill.

Because fund flows have been shown to be highly persistent, mutual funds with past inflows (outflows) are expected to receive additional capital (redemptions), expand (liquidate) their existing holdings, as well as drive up (down) their own performance in subsequent periods. This is a very different explanation than the “smart-money” hypothesis.

In their study “What Drives the “Smart-Money” Effect? Evidence from Investors’ Money Flow to Mutual Fund Classes,” published in the January 2017 issue of the Journal of Empirical Finance, George Jiang and H. Zafer Yuksel found that the flow/performance relationship explains the short-term outperformance.

Before concluding, I’ll review some of the other evidence on Morningstar ratings and future performance.

When You Wish Upon A Morningstar

The November 2009 issue of Morningstar’s FundInvestor provided the following evidence on its five-star funds:

  • The 2004 class of five-star domestic funds had a five-year rating of just 3.2 stars, just slightly above average. The average fund underperformed its risk-adjusted benchmark by more than 1%.
  •  The 2005 group of five-star funds turned in a three-year rating of just 3.1 stars.
  • The 2006 group had a three-year rating of just 2.9 stars.


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