The December edition of the semi-annual S&P Persistence Scorecard brings better news than the July report — performance persistence of top mutual funds has slightly improved. However, percentages of domestic equity funds remaining in the top half of population for three or five consecutive 12-month periods were generally lower than those expected by mere chance.

Period Ending Top Half Expected
3 Years Mar-13 18.36% 25%
3 Years Sep-13 22.38% 25%
5 Years Mar-13 3.59% 6.25%
5 Years Sep-13 6.47% 6.25%

Only 7.23% of all funds remained in the top quartile for three years and 2.11% for five years to September. While this beat random expectations of 6.25% and 0.39%, respectively, figures for the same periods ending in March were 4.69% and 0.18%.

In this context, an InvestmentNews article says that

S&P’s findings reinforce the idea that short-term performance chasing in mutual funds is likely to end badly for advisers, but for long-term investors, the lack of persistence doesn’t necessarily mean a bad outcome, provided you can stomach the volatility.

The article gives an example of this year’s top-performing large-cap blend fund, the MFS® Equity Opportunities Fund (SRFAX; Class A shares), which beat 90% of its peers and the S&P 500® index by annualized 2% in the trailing five years, despite a rocky performance:

The fund’s journey to five years of outperformance wasn’t smooth though. In 2009 it ranked in the bottom 10th percentile of large-cap blend funds and in 2011 it ranked in the bottom half of its category.

The article concludes that:

So if you can handle a fund that dips every now and again, without a big change to the investment process or management, the lack of persistence shouldn’t matter over the long run.

This example, however, forgoes important details. First, although Morningstar classifies the fund in the large-blend category, the prospectus benchmark for the fund is the Russell 1000® index. Unlike the S&P 500®, that benchmark includes medium-capitalization equities. As of this writing, the annualized five-year return of the fund was 19.09% vs. 18.41% of the iShares Russell 1000 (IWB), a difference of only 0.68%.

Second, compared to its stated benchmark the fund’s holdings are tilted toward mid- and small-cap stocks (collectively, about 46%) at the expense of giant-cap ones. This, again, indicates, that a pure large-cap index is an inappropriate reference.

Third, let’s use Alpholio™ tools to further peek under the fund’s hood. Here is a chart of weights of exchange-traded funds (ETF) in the reference portfolio for the fund:

Reference Weights for SRFAX

The fund had top-four equivalent positions in the iShares S&P 500 Growth ETF (IVW; average weight of 23.8%), iShares S&P Mid-Cap 400 Growth ETF (IJK; 23%), PowerShares Dynamic Market Portfolio ETF (PWC; 21.2%), and iShares Morningstar Mid-Cap Growth ETF (JKH; 6.8%). This underscores the fund’s tilt toward not only mid-cap but also growth stocks.

Relative to the reference portfolio, the fund’s performance in the same analysis period was unimpressive:

Cumulative RealAlpha™ for SRFAX

The fund underperformed in 2009, so on a cumulative basis, its RealAlpha™ did not rebound until 2013. By this November, an investor who started with the fund in early 2005 would have not yet beat the reference ETF portfolio, as shown by the lag RealAlpha™ curve. In addition, the reference portfolio exhibited a lower volatility. (To get more information about this and other funds, please register on our website.)

The lack of performance persistence in mutual funds does matter in the long run and is more pronounced the longer the run is. In addition, as the above analysis demonstrated, relative performance heavily depends not only on the timeframe of the analysis, but also on the proper choice of the benchmark that fully adjusts for a fund’s risk.

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