The latest semi-annual S&P Persistence Scorecard study again demonstrates that the quest for performance persistence of actively-managed mutual funds is as futile as the famous resistance to the Borg in Star Trek. The majority of well-performing funds will be “assimilated” from the top quartile into the lower quartiles or from the top half into the bottom half of the fund population after both three and five years. The percentage of funds remaining in the top quartile or half after either period is much smaller than that implied by random expectations (chance), which indicates that active management skills are very fleeting.
While the study certainly brings value, it would be better if it compared actively-managed mutual funds not against each other but against an independent market benchmark specific to each fund category. Since an average fund underperforms such a benchmark by slightly more than the average expense ratio, fewer than half of the funds would beat it. In other words, if the performance bar were raised from a “relative” to an “absolute” level (as Alpholio™ does in its analyses), the distribution of funds would be much more skewed to the left, i.e. below the benchmark. However, such a distribution would truly reflect all the investment vehicles available to the investor, including index funds and exchange-traded products (ETPs). Chances are that in that case performance persistence would be even worse than the one shown in the study.
The findings of the study are corroborated by Morningstar in the analysis of its fund rating system:
“Fifteen years previously, the seminal paper on the topic, Mark Carhart’s ‘On Persistence in Mutual Fund Performance,’ offered this as its first and main conclusion: ‘Avoid funds with persistently poor performance.’
Morningstar’s research on the predictive power of its Morningstar Rating for funds (aka the star rating) further supports the notion. For most time periods, the star ratings do show mild persistence across the ratings bands, with the higher-rated funds in aggregate scoring better total returns over the next time period than the lower-rated funds. The finding is at its strongest, though, at the bottom.”
Since the statistical evidence shows that there is little long-term persistence of outperformance, the only solution is to focus on a shorter time frame. Because risk profiles in a given category vary widely across both funds and in time, a custom and dynamic benchmark has to be devised for each fund. This is exactly the methodology Alpholio™ uses. While no analytical approach based on historical data can guarantee a perfect prediction of future performance, smoothed cumulative RealAlpha™ curves do exhibit a certain degree of momentum for most funds. An investor can use this information to capitalize on fund outperformance trends, while avoiding periods of underperformance on a truly risk-adjusted basis.