Most investors and investment professionals that I have met, believe that a fund that has performed well in the past can be expected to perform well in the future. The perception of what constitutes good performance could vary from person to person. Yet, on the other hand, in the statutory risk factors that accompany the promotional material for any scheme, there is a clear suggestion that past performance does not indicate future performance.
When I point out this apparent contradiction to investors or advisors who support such analysis of past performance, I usually hear responses that suggest that the risk factors allude to absolute performance and not relative performance. So, what really is the truth?
I believe that performance results from a combination of skill and luck- a mix that can be too volatile to be predictable. Even if the level of skill were to remain constant, the degree of luck, both good and bad, could well throw any prediction on absolute performance, way off the mark. When you consider that this applies to every fund manager, one could make the case that relative performance is even more difficult to predict.
For those who may find this point somewhat difficult to appreciate, there is the alternative way of examining the evidence.
A few weeks ago, I looked up the calendar year performance of various equity funds from 2004 to 2013 to see if the relative performance in any given year repeated itself in subsequent years. My universe consisted of diversified domestic equity funds that were part of the following categories of Value Research:
- Equity – Large-Cap
- Equity – Large and Mid-Cap
- Equity – Small and Mid-Cap
- Equity – Multi-Cap
- Equity – Tax Planning
There were, in all, 89 funds across these categories, which had been around since 2004.
I grouped these funds in quartiles based upon their yearly returns. Here are some of the observations:
There was very little predictability to the quartiles that any fund ended up in. 82% of the funds were, in one year or another, in the top quartile while 92% were, in one year or another, in the bottom quartile. 56% of the funds were, in one year or another, in each of the four quartiles while each of the remaining funds were, in one year or another, in one of three quartiles.
70% of the time, funds ranked in the top quartile in a particular year, ended up in a lower quartile in the subsequent year. 28% of the time, such funds moved from the top quartile to the bottom quartile in the subsequent year.
46% of the time, funds ranked in the top half in a particular year, ended up in the bottom half in the subsequent year.
As far as I could make out, past performance was no indicator of the future.
Make no mistake, though: no matter what I say or what the statutory ‘risk factors’ related to investing in funds declare, it is an uphill task to fight the impulse to look at the past to tell the future.
In case you would like to see or analyze the data for yourself, I have put together an Excel file that can be downloaded here.
