Past Performance Is No Predictor of Future Results

“Historical investment performance” is a typical sales pitch used in marketing campaigns for mutual funds. However, as research shows, past performance is no predictor of future results.

In June 2010, Standard and Poor’s released a white paper entitled “Does Past Performance Matter?” The results of the study were revealing. For the five-year period ending March 31, 2010, only 3% (roughly 29 funds) of 1,068 U.S. equity mutual funds maintained a performance ranking in the top-half over five consecutive 12-month periods. Very few of the funds studied consistently repeated top-half performance. Longer-term performance was similarly unimpressive. Less than 25% of 1,581 U.S. equity mutual funds with a top-quartile ranking over the five years ending March 2005 were able to maintain a top-quartile ranking over the next five years.

The Legg Mason Capital Management Value Fund, a large-cap value fund, may best exemplify the challenge of repeating strong historical performance. While the fund posted an industry-record streak of beating its benchmark (the S&P 500 Index) for 15 consecutive years, it declined 7% in 2007 and then declined another 55% in 2008. In 2007 and 2008, the S&P 500 Index generated better results each year, advancing 5% and declining 37%, respectively.

Despite the lack of persistent top-quartile performance among mutual funds, interestingly, there is consistency in the failure rates of bottom-quartile funds. For the five-year period ending March 31, 2010, bottom-quartile funds had a 43% chance of merging with another fund or liquidating. Mutual funds that exhibit bottom-quartile performance are often shut down, but top-performing funds do not necessarily maintain their top position.

Chasing Past Performance

According to Morningstar, four-star and five-star rated mutual funds captured about three-quarters of the roughly $2 trillion of net inflows into all “star-rated” mutual funds over the 10-year period ending December 31, 2009. This suggests that investors are prone to chase past positive performance.

Cambridge Associates, a consultant for institutional investors, studied the impact of chasing past performance and the outcome of firing “underperforming funds” (defined as funds with below-benchmark returns but not in the bottom quartile) and replacing them with “top-performing funds.” The fired funds often began to outperform, while the newly hired funds began to underperform. By chasing past performance, investors were mostly selling at the bottom and buying at the top—quite the opposite of the time-tested “buy low/sell high” strategy. In fact, more than two-thirds of the mutual fund changes were harmful to performance.

Consider, for example, the Internet bubble of the late 1990s. Imagine how chasing double- and triple-digit returns worked out for investors after the market peaked.

Other Factors to Consider

Investors need to consider other factors besides historical performance results when investing in mutual funds, such as fees, turnover (how often securities are bought and sold), clearly defined and consistent investment strategies, and portfolio diversification.

The General Board manages its funds with these factors in mind and offers exceptionally diversified portfolios allocated across multiple investment classes and styles. General Board funds offer excellent value when compared with mutual fund peers. So, the next time you assess mutual fund historical performance, remember the old adage: “Past performance is no predictor of future results.” For a detailed look at the General Board’s funds, access the Investment Funds Description at www.gbophb.org/TheWell/Root/ALL/3052.pdf.