I believe there are people out there who can beat the market. However, I also believe they are few and far between, and that they are essentially impossible to identify in advance. I am also a firm believer that very few of them manage mutual funds. The latest “Persistence Scorecard” published by Standard and Poors provides another chunk of evidence (as if we didn’t already have enough) that past performance is a particularly bad way to pick an actively-managed mutual fund. The summary results are worth reviewing:
Very few funds manage to consistently repeat top-half or top-quartile performance. Over the five years ending March 2011, only 0.96% of large-cap funds, 1.14% of mid-cap funds and 2.59% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Random expectations would suggest a rate of 6.25%.
Looking at longer-term performance, 19.15% of large-cap funds with a top-quartile ranking over the five years ending March 2011 maintained a top-quartile ranking over the next five years. Only 9.38% of mid-cap funds and 23.26% of small-cap funds maintained top-quartile performance over the same period. Random expectations would suggest a rate of 25%.
While consistent top-quartile and top-half repeat rates have been at or below levels one expects based solely on chance, there is consistency in the death rate of bottom quartile funds. Across the board, fourth-quartile funds have a much higher rate of being merged and liquidated than all other funds.
The moral of the story is that you are far better off not playing a loser’s game of trying to find a mutual fund manager who can beat the market. Get the market returns at the lowest possible cost by using index funds. Eliminating the risk of underperformance is well worth giving up the slight possibility of outperformance, especially when it is likely to be very short-term.
What would you think of a doctor who didn’t consider the evidence when prescribing therapies? Why would you look at investing any differently? It has a body of evidence and peer-reviewed journals just like medicine. A physician familiar with a handful of the basic theories is likely to end up far more wealthy than one who never considers the evidence.