The Winners Lose
Based on the historical evidence that there’s persistence of underperformance among the highest-cost funds, the authors eliminated the funds in the top decile of funds ranked by expense ratio from their sample. The dataset covered the period from 1994 through 2015. Portfolios were formed based on funds’ most recent 36-month performance and rebalanced monthly to maintain equal weighting across funds. At the end of the three-year period, the process was repeated. The following is a summary of their findings:
- The winner strategy produced by far the lowest return (8.0%) and the worst Sharpe ratio (0.29). The returns and Sharpe ratios for the median and loser strategies were 9.8% and 0.48%, and 10.4% and 0.51%, respectively.
- The Carhart four-factor model (beta, size, value and momentum) alphas were -2.7% for the winner strategy (with a t-stat of -3.0), -0.4% for the median strategy (with a t-stat of -0.9) and 0.2% for the loser strategy (with a t-stat of 0.2).
Shockingly—at least for those who believe in using past performance to make hiring and firing decisions—switching from the winner strategy to the loser strategy would have resulted in almost doubling the Sharpe ratio of the portfolio (from 0.29 to 0.51). In addition, the four-factor alphas of the winning strategy were highly negative, at -2.7%, and statistically significant at the 1% confidence level (t-stat of 3.0). In addition, it was 2.9 percentage points below the four-factor alpha of the loser strategy.
This certainly calls into question the belief that past outperformance was the result of any skill. What’s more, paying fees to consultants to help you make these hiring and firing decisions would only add to the negative impact of such a strategy.
Mind The Gap
These findings help explain the well-documented “returns gap” (what my colleague and fellow author Carl Richards called “the behavior gap”) experienced by individual investors. Due to performance chasing, the returns they earn are below the returns of the very funds in which they invest.
Providing more fuel for the fire, Cornell, Hsu and Nanigian found that the strategy of investing in the funds that underperformed their benchmarks by more than 1% actually outperformed the strategy of buying funds that beat their benchmarks by more than 1% (9.8% with a Sharpe ratio of 0.48 versus 8.7% with a Sharpe ratio of 0.37). The losers produced a four-factor alpha of -0.4% (with a t-stat of -0.7), while the winners produced an alpha of -1.7 (with a t-stat of -3.4).
The findings were the same for the strategy of investing in the funds that underperformed by at least 3%. They managed to outperform the funds that had outperformed by at least 3% (10.0% with a Sharpe ratio of 0.48 versus 8.9% with a Sharpe ratio of 0.39). The losers produced a four-factor alpha of -0.2% (with a t-stat of -0.4) while the winners produced an alpha of -1.4 (with t-stat -3.3). It doesn’t get much uglier than that.
To test the robustness of their findings, the authors also examined a 24-month horizon instead of a 36-month one. The results changed little.
Looking At Expense Ratios
In another interesting test, the authors started with a universe of the top 90% of managers ranked by lowest expense ratio and computed their annualized future outperformance from the selection date to the end of the performance reporting sample—in other words, perfect foresight. They then examined the impact of starting with this fund universe and additionally screening funds based on recent performance. Once again, they found the same results.
Equal-weighting the top 25% of winners would have returned 12.3% (with a Sharpe ratio of 0.61). However, then screening for the most recent winners would have lowered returns to 10.6% (with a Sharpe ratio of 0.43) while screening for the most recent losers would have returned 13.5% (with a Sharpe ratio of 0.68).
The authors write: “Even if investors start with a select list of good managers, using recent outperformance to further screen managers is a harmful practice.” And their findings are consistent with those of prior research on the hiring and firing decisions of pension plans and other institutional investors. Consider the following …