Swedroe: Past Performance Deceives

November 10, 2017

Cornell, Hsu and Nanigian concluded: “We find that the common selection methodology turns out to be a detriment to performance.”

They added: “The greater benchmark-adjusted return to investing in ‘loser funds’ over ‘winner funds’ is statistically and economically large and is robust to reasonable variations in the evaluation and holding periods, as well as to standard risk adjustments. We also found that the standard practice of firing managers who have recently underperformed actually eliminates those managers that are more likely to outperform in the future.”

These findings are entirely consistent with previous research. Take note of the publication dates of the studies cited below. You’ll see that the evidence on using past performance to select actively managed funds has been there for a long time for all to see. Yet the evidence continues to be ignored by a large majority of investors, both institutional and individual.

Supporting Evidence

Rob Bauer, Rik Frehen, Hurber Lum and Roger Otten, authors of the 2008 study “The Performance of U.S. Pension Plans,” examined the performance of 716 defined benefit plans (over the period 1992 through 2004) and 238 defined contribution plans (over the period 1997 through 2004). They found that returns relative to benchmarks were close to zero. They also found no persistence in performance.

Importantly, the authors also found neither fund size, degree of outsourcing or company stock holdings were factors driving performance. This refutes the claim that large pension plans are handicapped by their size. Smaller plans did no better.

They concluded: “We show striking similarities in net performance patterns over time, which makes skill differences highly unlikely.”

Bauer, Frehen, Lum and Otten also studied the performance of mutual funds, adding to our body of evidence on them. As you should expect, the news for individual investors is even worse.

While pension plans failed to outperform market benchmarks, on a risk-adjusted basis, mutual funds underperformed pension plans by about 2% per year. Pension plans are able to use their size (negotiating power) to minimize costs and reduce the risks of any conflicts of interest between fund managers and investors.

The authors attributed the underperformance to the incremental costs incurred by mutual fund investors.

Counterproductive Activity

The 2008 study “The Selection and Termination of Investment Management Firms by Plan Sponsors” by Amit Goyal and Sunil Wahal provide even further evidence on the inability of plan sponsors to identify investment management firms that will outperform the market after they are hired.

In their study, Goyal and Wahal examined the hiring and firing of investment management firms by plan sponsors (public and corporate pension plans, union pension plans, foundations and endowments). They built a data set of the selection and termination decisions of about 3,400 plan sponsors from 1994 to 2003. The data represented the allocation of over $627 billion in mandates.

Following is a summary of their findings:


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