Mutual funds: Is there correlation between past performance and future performance?


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".

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