Moreover, funds that have outperformed their benchmark over the past three years tend to underperform funds with a mediocre or poor performance record over the next three year-period.
We all know that past performance is not an indicator of future performance. This does not, however, stop investors from piling into ‘winner’ funds and selling out of funds that have shown disappointing performance. They hope such tactics will improve the performance of their portfolios in the long run.
However, they would do better selling their top performers and buying funds that have underperformed their benchmark, according to a study[1] carried out by Bradford Cornell (California Institute of Technology), Jason Hsu (Anderson Graduate School of Management at UCLA) and David Nanigian (California State University).
They found that a portfolio consisting of the top-decile performing US equity funds in the previous three years lagged a portfolio made up of average performing funds over the next three-year period by more than 100 basis points. A so-called ‘loser strategy’, comprising the 10% worst performing funds over the previous three years, did even better, underperforming its benchmark by just 0.11%, compared to 2.39% for the ‘winner strategy’. The Sharpe ratio of the loser portfolio is also almost twice as high as the Sharpe ratio of the portfolios comprised of winner funds.
The results also hold when controlled for volatility, size, value and momentum factors in stock returns (see table): the Carhart four-factor alpha is significantly higher for the ‘loser strategy’ than for the ’winner strategy’.
The results of the study chime with previous research conducted by Expert Investor into European equity fund performance, which found that funds that show top-quartile performance in one year are unlikely to repeat that over the next two years.
[1] Their paper is called “The Performance Impact of Alternative Methods for Choosing Investment Managers”(2016)
The power of momentum
So why could it be that winning funds turn into losers and vice versa? The authors suggest this could have something to do with momentum on the fund level. “Our argument is related to Woolley and Vayanos’ [2012] Theory of Asset Mispricing. They show that performance-chasing flows will create short-term momentum in the performance of winner managers but also reversal when the flows reverse out to chase the next winner strategy a few quarters hence.[2]”
The study risks being affected by survivorship bias since underperforming funds are more likely to be shut down than their well-performing equivalents. The authors control for this by using the Morningstar Direct survivor-bias-free United States Mutual Funds Database. They do not, however, control for sector exposure, which is a major driver of returns for equity funds. Differences in sector exposure could possibly explain some of the discrepancy in returns between the ‘winner’ and ‘loser’ portfolios, but probably not all of it.
However powerful their results are, the authors are under no illusions that investors will prefer poorly performing funds over well-performing ones after reading their paper. “Despite our findings, a policy of firing successful managers and replacing them with poor performers is not likely to gain widespread acceptance,” they acknowledge[3].
Instead, they suggest fund selectors should instead focus on metrics that are better predictors of performance, such as the investment strategy of a fund, manager ownership, active share and total fund fees.
[2] The Performance Impact of Alternative Methods for Choosing Investment Managers, Brad Cornell, Jason Hsu & David Nanigian(2016)
[3] The Performance Impact of Alternative Methods for Choosing Investment Managers, Brad Cornell, Jason Hsu & David Nanigian(2016)
