Exchange and Blodget agree:
past performance is no guide to future results, when it comes to mutual-fund
returns. Is this true? I posed
the question back in 2004, when I wrote this:
When a rather obnoxious man at Citibank tried to sell me some mutual funds
once, based on their outperformance, I actually spent quite a bit of time
researching this issue. Companies like Morningstar generally group funds into
quintiles: the top 20%, the next 20%, and so on. And there is in fact a certain
amount of correlation between past performance and future performance. Not
a lot, but a little. Funds in the bottom quintile will tend to underperform
in the future, funds in the fourth quintile will underperform but not quite
as badly, and funds in the top three quintiles are all roughly equally likely
to outperform in the future.
This generated a little bit in the way of comments. Said Simian:
Actually the academic evidence points primarily to a random walk when it
comes to mutual fund performance. Morningstar ratings – which are currently
based on risk-adjusted, peer-relative trailing returns for various horizons
(1 year, 3 year, 5 year, etc) – have generally been shown to be non-persistent
(Blake & Morley). So prior good performance does not suggest that future
performance will be particularly good or bad; it’s merely noninformative.
The studies which did find some, albeit not very strong, persistence (Warshawsky)
suggested that economies of scale played a role. In other words, if a fund
did well, assets poured into it, and a large fund is better able to control
and allocate costs, to a degree which overcomes the increased market impact
of its trades.
Which is actually the opposite of what Blodget is saying, which is that larger
funds are less likely to outperform.
The big message, of course, is clear: don’t buy mutual funds. And that’s good
advice even if it is followed by "every economist I have ever
met," to quote the Economist’s blogger. At the margin, however, is there
some kind of correlation between past performance and future performance? I
think Simian might have been referring to this
paper, by Elton, Gruber, and Blake, but it says that "We find that
past performance is predictive of future risk-adjusted performance".