PAST PERFORMANCE

"The key issue is that past performance is a thin reed for how to predict future performance. Expense ratios and turnover are generally better predictors."

William Sharpe

(Investment Adviser) Most investors who do any review of investments invariably look at past track records as an indication of how they fund might do in the future. But that really doesn't work (long term) and never has. The future performance is based on a randomness that means all funds will tend to even out over time. A study by Barksdale and Green of 144 institutional equity portfolios over the rolling 10 year periods between January 1, 1975 and December 31, 1989 showed that portfolios that finished the first five years in the top quintile were actually the least likely to finish in the top half over the next five years. The results were entirely random. The results, averaged together over all six rolling time periods, looked like this:
Performance Ranking % that finished in the top 50% in the first five years Those that finished in the top 50% over the next 5 years
Top 25% Performers 44.83%
Second 20% performers 47.67
Third 20% performers 51.50
Fourth 20% performers 52.33
Fifth 20% performers 0.99

Another study by Robert Ludwig effectively noted the same results. He looked at portfolios that finished among the top 25% of all equity funds tracked by SEI Corp for the previous five years and the bottom 25% for the same period. Next he looked at how many of those portfolios finished in the upper half of all performers for the next five/four/three/two and one year periods. Performance of these top performers and bottom performers was then compared relative to the median performer over subsequent periods. The results showed that among the top performers from the five year evaluation period of 1981 to 1985, only 48% performed above the median over the subsequent five year period, 1986 to 1990. This means that 52% of the top performers in the first period ranked BELOW the median in the second period. Surprisingly, 50% of the bottom performers performed above the median in the second period. The figures below showed that the past performance of investment managers and mutual funds had virtually NO predictive ability for future long term performance.
Performance Ranking over prior 5 year periods Percentage in the top 50% over selected time periods
Top 20% 47.9 46.4 50.0 48.2 53.3
Bottom 20% 50.0 50.9 39.7 51.8 41.1


Another study reviewed the Forbes Honor Roll over periods of 1980- 1984 and 1986- 1990. Only once did those in the honor roll outperform, in the aggregate, the S&P 500 index- and that by a very slight margin in the first five year period. Further, the group never outperformed both the index and the average equity fund during any five year periods.

So is there any connection at all? Lipper found that, In the extreme, with the very good and the very bad funds, there does tend to be repetitive performance under similar conditions. But the key here is similar conditions. If you can be relatively certain of the conditions existing in the future, then a correlation does appear for predicting how well a fund might do on past ranking. So is this really easy to do? Well, if it was, everyone would be doing it and everyone would be millionaires. Realistically, the effort is almost futile, save for the immediate future and a remarkably objective and intuitive insight. William Sharpe noted that on a net of expense basis, in the aggregate, fund and institutional managers will tend to underperform the market by an amount equal to the fees that take for managing the portfolio, plus associated costs. Vanguard's Bogle's study of the Wilshire 5000 Index from 1971 to 1990 tended to show exactly that- professional managers underperformed the index by an average of 1.8% per year- approximately the cost of managing the fund; 1% for management fee, 0.5% in fund transaction costs and 0,3% due to cash positions required by investor inflows and outflows. Another study by Brinson, Hood and Beebower (mentioned previously) of the quarterly returns of 91 large pension funds between 1974 to 1983 compared the returns from the asset classes they were investing in. 93.6% of the return was explained by the movements In the underlying asset classes they were investing in. They also showed that active managers, in the aggregate, underperformed the benchmarks by 1.10% a year. In other words, the active selection of stock did little to nothing to the overall return- it was where the money was invested that made the difference.

STATISTICS: As a continuation on the above commentary, it is true that some managers may bring a level of skill into the playing field- at least for the short term. If you could identify which ones they were, it could be possible to handily outperform the basic index funds. Some analysts say that additional skill could provide up to 5% greater return than index funds. (While I generally agree with that, I think it is more prevalent in non efficient markets where indexing is not highly recognized- in the most recent past that has been international markets.) Over the past 10 years however, some actually did show a big spread over an index. So something must be going on- or is it? First, I believe that in a solidly increasing market, management skill may be worthwhile since the analysis of financial statements in an increasing market may actually identify those companies that could provide a return above the norm. Unfortunately, it is almost always after the facts are in that the trend may have become apparent. In any case, simply picking a fund with a higher past return still doesn't meant that you are getting skill. Secondly, some managers may have been lucky. The kicker here is that it is almost impossible to determine who is lucky and who is skillful. For example, if you have a manager beating the market by 200 basis points, it could take more than 70 years to know with a 95% degree of confidence whether it was luck or skill. Of course, by that time both you and he/she are already dead.

There is also the issue that even if you did identify a manager that actually did provide skill, is there any guarantee that he/she will continue to provide it? Nope, primarily because in most situations, the conditions in which the returns came are already gone and the manner and style the manager used is no longer productive.

MORE STATISTICS: Look at these numbers carefully. First, some one time performers may actually repeat themselves the next year- Oppenheimer Target in 1981 and 1982 being the most pronounced. Yet, if you had picked Oppenheimer Regency in 1983, you would have lost 23% the next year since economics and strategies had already changed. Recognize that some of these funds were top performers only because they took an inordinate amount of risk- 44 Wall Street for example. And also note that the two top performers- 44 Wall Street in 1975 and Strategic Investments in 1979- are not even around anymore. And during the last ten years in particular, most of the funds were sector funds- the highest risk.
Open end Fund Year Top Return Following Year return
Templeton Growth 72 69% -10%
International Investors 73 92 11
Sherman Dean 74 25 20
44 Wall Street 75 184 47
Sequoia 76 73 20
Value Line Leveraged Growth 77 52 28
Merrill Lynch Pacific 78 59 -23
Strategic Investor 79 195 74
Hartwell Emerging 80 94 -13
Oppenheimer Target 81 48 81
Oppenheimer Target 82 81 25
Prudential Utility 84 39 33
Fidelity Overseas 85 79 69
Merrill Lynch Pacific 86 78 11
Oppenheimer 90/10 87 94 -5
Columbia Special 88 43 32
US Gold Shares 89 65 -34
Oppenheimer Global Biotech 91 121 -23
Fidelity Select S&L 92 58 27

Cumulative Compound Return 2,076%

S&P 500 1,119%

There is no question that if you picked right, you could easily outdistance the S&P market as a whole. But you probably had a risk at least 1.5 times greater than the market. And no asset allocation.

Here are some more statistics from the WSJ regarding performances for the 1980's and the first five years of the 90's.
Fund 10 yrs to 12/311989 5 year to 12/31/1994
Fidelity Magellan 28.55 12.05
Merrill Lynch Pacific 26.4 6.1
Japan Fund 22.6 -0.5
CGM Capital Development 21.9 18.7
Phoenix Growth Fund 21.8 7.8
Lindner Fund 21.4 8.0
New England Growth Fund 21.0 9.7
Janus Fund 20.7 10.7
Phoenix US Stock Fund 20.7 7.1
Lindner Dividend Fund 20.7 9.9
AIM Weingarten Fund 20.5 9.1
Twentieth Century Select 20.4 5.7
GT Pacific Growth 20.4 3.6
IDS New Dimensions 20.3 13.1
New York Venture 20.3 11.8
Fortis Capital Fund 20.1 8.7
Vanguard Windsor 20.1 8.6
Fortis Growth Fund 20.1 9.9
SteinRoe Special 20.1 10.9
Fidelity Destiny 20.0 15.4
United Vanguard 19.9 9.0
S&P 500 17.6 8.7
Average Stock Fund 15.5 9.2

In summary, it is mandatory to look at past performance of a fund. It is also mandatory to recognize that past performance is absolutely no guarantee of future performance. Nonetheless, some activity in the past may carry over, at least for a period of time, into the near term and provide good returns. However, running at the best fund for the past month or year without utilizing proper asset allocation is probably a fool's errand and fraught with higher risk .

Lastly, as one analyst said and on which I definitely agree, "the investor today has to spend more time ferreting out what might be good for the next few years than spending time going over old history."

RETURNS: (2000) Just a table I am including in a report that shows how well funds have beaten an index over a certain period of time.

Table 1

Year Return of the Index Fund Average Return of 198 Funds +/- the Index Fund Number Beating the Index Fund Percent Beating the Index Fund
1985 31.23 28.38 -2.85 63 32
1986 18.06 15.58 -2.48 67 34
1987 4.71 2.96 -1.75 69 35
1988 16.22 13.71 -2.51 69 35
1989 31.37 25.86 -5.51 44 22
1990 -3.33 -4.04 -.71 94 47
1991 30.22 33.08 2.86 104 53
1992 7.42 7.01 -.41 85 43
1993 9.89 11.58 1.69 118 60
1994 1.18 -1.54 -2.72 47 24
1995 37.45 31.26 -6.19 26 13
Average 16.00 14.20 -1.80 71 36
Growth of $100 from 1990-1995 $511.86 $ 430.86 -$81.00 NA NA

REPEAT PERFORMERS: (2000) The top 10% of funds in any 12 month period since 1988 dropped to the 48th percentile the following year. During the same period, about 40% of the past performers had better than average performance the following year.

Prem C. Jain of Tulane University, and Joanna Shuang Wu of the University of Rochester, examined 294 advertised US equity mutual funds. (2000)In their  controlled study, they measured the performance of the mutual funds one-year prior to the first advertisement date, and one year after. The study concluded that the advertised funds performed well above average prior to the advertisement date, but below average in the in the post-advertisement period (the below-average returns were not statistically significant). The study also found that advertised funds attracted significantly more capital than similar funds in the post-advertisement period, even though the results of all funds going forward were very close to a random event. All three measures of performance showed that the 294 funds achieved superior returns prior to the first advertisement and elements of under-performance in the twelve months after the first advertisement.

It is clearly evident that past performance is not a strong indicator of   future returns.

Are the fund companies acting in an ethical manner? Are they encouraging the public to invest a way that is to the detriment of the average investor and to the benefit of the investment industry? Are the Board of Directors of these mutual funds, whose responsibility is to protect shareholders, looking the other way as marketing department takes charge? 

Richard Ferri

The Grand Infatuation by William Bernstein, Brill.com. (2002) The author presents the summary data from a study by Micropal showing that the top funds in any five year period underperformed the S&P 500 index in the subsequent five year period. ("Starting with 1970, they looked at the top 30 domestic diversified funds for a given 5 years and followed their performance out to June 1998.")

Active versus Passive (Swedroe 2002) There will always be some active managers that outperform their appropriate benchmark, even for very long periods of time. This provides hope for believers in active management. Unfortunately, there is no evidence of any persistence in performance beyond the randomly expected. Nor is there any demonstrated ability to identify ahead of time the very few winners. What is even worse is that the evidence over long periods is that the very few winners outperform on an after tax basis by a very small amount, and the losers underperform by a much larger amount, about three times greater. So even if you manage to pick one of the few active funds that outperforms, the odds are great that you will outperform by only a small amount. On the other hand, the odds are great that you will choose an active fund that will underperform by a large amount.

One study found that for the ten-year period 1982-91, on a pretax basis, just twenty-one percent of the funds outperformed their benchmark, Vanguard's S&P 500 Index Fund. The average outperformance was 1.8 percent per annum. The average underperformance was a similar 1.9 percent. On an after-tax basis, however, only about eight percent of the funds managed to beat their benchmark. The average outperformance was now just 0.9 percent, while the average underperformance increased to 3.1 percent.

Keep this in mind: the ratio of about 3.5:1 (the 3.1 percent underperformance divided by the 0.9 percent outperformance) in favor of the underachievers is made all the more significant because there were about eleven times as many losers as winners. Thus, we find that not only are there far more losers than winners, but also that the average size of the underperformance is far greater than the size of the outperformance. Therefore, we need to look at the risk-adjusted odds of outperformance. We can calculate that by multiplying the odds of outperformance by the ratio of underperformance to outperformance. Doing so gives us risk-adjusted odds against outperformance of about thirty-eight to one.

The same study then looked at the ten-year period 1989-98, and found that on a pretax basis, just fourteen percent of the funds outperformed, with the average outperformance being 1.9 percent. The average underperformance was 3.9 percent. On an after-tax basis, only nine percent of the funds outperformed. The average outperformance was 1.8 percent. The average underperformance was 4.8 percent. The risk-adjusted odds against after-tax outperformance are about twenty-eight to one.

Bye bye: (WSJ 2002) John Bogle, founder of Vanguard Group in Malvern, Pa., notes that some 6½% of stock funds are killed off each year, double the failure rate of just a few years ago. When a fund is killed off, it's often merged into another fund with lower costs and a more sensible strategy. That's good for shareholders. But it's even better for fund-management companies, because they get rid of embarrassing funds that are often generating scant profit for the fund companies involved."

And figures can lie and liars can figure. "According to Chicago's Morningstar Inc., U.S. stock funds returned an average 13.8% a year over that stretch, just a smidgen behind the 14.3% for the Wilshire 5000-index of almost all U.S. stocks. This fund average was built by stringing together the calendar-year results for funds that were around in each year, and are still around today. If actively managed funds lag behind the index by just 0.5 percentage point a year, the case for index funds would seem rather weak. the 13.8% doesn't include all the fund industry's failures. What if you add back the funds that have since been liquidated or merged out of existence? That knocks more than a percentage point off the 20-year average, dropping it to 12.7% a year."

Previous stock reaction  (NY Times 2005)  

The Fed has raised its target for short-term rates 1.75 points since June 30. How the S&P 500 has performed following past 1.75-point increases:

                   .                   3 mos. 6 mos. 1 year

Aug. 9,  1929                 -30% -20.2% -34.1%

Oct. 16,  1931               -16.2% -38.2% -37.3%

Aug. 23,  1957                 -6.9% -7.6% +6.8%

May 29,  1959                +3.0% +1.4% -3.0%

May 11, 1973                -2.6% -8.8% -6.9%

May 11,  1978               +6.1% -3.2% -0.4%

Nov. 17, 1980               -5.5% -0.6% -13.8%

Nov. 15, 1994              +3.4% +15.6% +28.7%

Average                         -6.1% -7.7% -7.5%

Source: InvesTech Research

That said, history does not have to repeat. Notice how only one period had pluses across the Board. Nice that it was recent. Useless because everything is different now.