Those people over at Standard & Poors spoil all the fun. Their periodic research reports on the performance of mutual funds routinely show the majority of actively managed mutual funds underperform the benchmark indexes the fund managers are so handsomely paid to beat. As if that indignity was not enough, twice a year they publish the "S&P Persistence Scorecard." It answers the question every active fund manager fears: Does past performance matter?
We all know that "past performance is not an indicator of future performance", but the financial media and the securities industry work seamlessly to convince us this is not true. Here's what I mean:
CNBC has "fund screener" on its web page.. It lets you find funds that have a history of stellar performance. Forbes touts its mutual fund screener that "...will help you find the right pick from our database of more than 2,600 funds that qualify for a Forbes Rating based on their track record in bull and bear markets."
TD Ameritrade lets you select certain criteria, including past performance, and screen for funds that meet your requirements. All of the major brokerage firms offer similar screens.
John Hancock recently launched a massive advertising campaign in which it featured the fact that many of its mutual funds are rated four and five stars by Morningstar. Presumably, the message is that its past performance is an important factor for investors to consider when shopping for mutual funds.
The latest S&P Persistence Scorecard presents irrefutable data indicating that this focus on past performance to predict future performance is simply nonsense.
Let's assume you used one of the fund screeners and identified each one of the 542 domestic stock funds that was in the top twenty-five percent of performers for the first year of the five year period measured by the Persistence Scorecard, commencing in September 2006. You decided to invest in all of them, confident that the majority would repeat their fine performance. After all, fund management is a skill, and these managers clearly had the secret to successful investing, right?
According to the Persistence Scorecard, your fund selections were a total bust. Not a single one of these top performing funds maintained its top quarter ranking in each of the remaining four years.
This is not surprising for those familiar with the data. When a fund outperforms, Wall Street tells you the fund manager has skill. In fact, it is just luck. Skill persists. Luck doesn't. If a fund family had investment skill, all of its funds would outperform the market. It would not be advertising just the few winners.
As investors, you need to screen out mutual fund screens and ignore past performance. Investing based on these factors is harmful to your financial wealth.
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Right, absolutely. The drumbeat of recommendations from all sides continues. And then you have all of the screening tools residing on fund company and brokerages sites. To they help? Not much. Virtually no one follows up his or her recommendations with review after the year in question is completed. Morningstar and others have failed to demonstrate the efficacy of their rating system. An article that gets investors part way to insight is "Streaks from Joltin' Joe to Mutual Fund Managers" on the Harvard Business Review blog http://blogs.hbr.org/cs/2011/02/streaks_of_success.html The study referenced demonstrates that streaks are real and that they are based on skill, as Joe DiMaggio's 56-game hitting streak was. It begs, but does not answer, the question of how to identify the mutual fund streakers. Investment Risk Management Systems is pursuing this by identifying and using new metrics to identify investment decision making capability, the disciplined people, processes, and systems that produce consistently superior results.
Do you know of other approaches that are proving successful at identifying the mutual fund "streakers"?
For these reasons, an investment strategy based on investing in broadly diversifed, very low-cost index mutual funds, that are re-balanced about once per year is very difficult to beat. This simple, but, elegant strategy, exemplified so well by the offerings and philosophy of the Vanguard Group mutual fund organization, is one that I have followed for over 25 years and has produced a very excellent investment outcome. I hardily recommend it for all small investors.
These investment "rules", if followed, will enrich most investors. Where does this lead you? Well, it leads you to an investment strategy that heavily utilizes broad, low-cost index funds. You will not hit many home-runs, but, you will not strike-out as often. Hitting for average, to use a baseball analogy, will yield you a lot of single hits, that will score a lot more runs, and keep a lot more money in your pocket, than the belief that you are smart enough, or lucky enough, to out-wit the pros on a regular basis.
By going with the market, you are betting on the long-run prosperity and growth of the US economy, and the long-run profitabilty of US business. You do not need to know a lot of fundmanmental, or technical theories or strategies. This approach is easy to implement, easy to follow and will allow you to put an automatic regulator on your emotionally-driven behavior by following a sensible long-run investment plan that is low cost, lower-risk and most importantly, really works.
Or you could do like we've done and put your 401K money into index funds.
We won't strike it rich, but thats not a retirement account is for anyway.