Chapter Nine

Yesterday’s Winners, Tomorrow’s Losers

Fooled by Randomness¹⁷

 

 

 

 

IN SELECTING MUTUAL FUNDS, most fund investors seem to rely, not on sustained performance over the long term, but on exciting performance over the short term. (Exhibits 5.2 and 5.3 in Chapter 5 reinforce this point.) Studies show that 95 percent of all investor dollars flow to funds rated four or five stars by Morningstar, the statistical service most broadly used by investors in evaluating fund returns.

These “star ratings” are based on a composite of a fund’s record over the previous 3-, 5-, and 10-year periods. (For younger funds, the ratings may cover as few as three years.) As a result, the previous two years’ performance alone accounts for 35 percent of the rating of a fund with 10 years of history and 66 percent for a fund in business from three to five years, a heavy bias in favor of recent short-term returns.

How successful are fund choices based on the number of stars awarded for such short-term achievements? Not very! According to investment analyst Mark Hulbert, a mutual fund portfolio continuously adjusted to hold only Morningstar’s five-star funds earned an annual return of just 6.9 percent between 1994 and 2004, nearly 40 percent below the 11.0 percent return on the Total Stock Market Index.¹⁸ To make matters worse, according to Hulbert, these highly rated funds were assuming even more risk than the market (average monthly volatility in asset value: 16 percent for the funds compared with 15 percent for the stock market).

Sadly, the orientation of fund investors toward recent short-term returns works worst in strong bull markets. Exhibit 9.1 shows the top 10 performers among the 851 equity funds in operation during the great “new economy” market bubble of 1997 to 1999. A wondrous group they were! Focused on Internet, telecom, and technology stocks, these funds generated an average return of 55 percent per year during the upswing—a cumulative return of 279 percent for the full three years. Remarkable!

EXHIBIT 9.1 Picking the Short-Term Winners: Annual Returns, 1997-2002

“The first shall be last.” And they were.

Well, you can guess what came next. The bubble burst, and, one by one, just as the Good Book warns, “The first shall be last.” Over the next three years (2000 to 2002 inclusive), every one of the original top 10 funds plummeted into the bottom 60, with not a single fund in the original top 10 ranked higher than 790. Fund 9 on the upside actually was last—851 on the downside. Fund 1 dropped in rank to 841; fund 2 dropped to 832, and fund 3 tumbled to 845. On average, the one-time 10 top funds in the bull market were outperformed by 95 percent of their peers in the bear market that followed. For investors who believed that the past would be prologue, it was not a pretty result.

Please remember that even a single annual gain of 55 percent followed by a loss of 34 percent doesn’t leave the investor with a 21 percent gain. More like 2 percent. (Do the arithmetic.) And with 3 years of average annual gains of 55 percent on the upside and annual losses averaging 34 percent on the downside (Exhibit 9.2), it was much worse. These aggressive new-economy funds ended up with a cumulative positive return averaging 13 percent for the full 6-year period, a far cry from the S&P 500’s cumulative gain of 30 percent. Yet while that return was not particularly satisfactory in terms of the traditional returns reported by the average equity fund, it was hardly a disaster.

But for the shareholders of the funds, it was a disaster. By investing after seeing those mouth-watering cumulative returns that had averaged almost 280 percent, achieved in a soaring bull market, nearly all the buyers of these funds had missed the upside. Then, not a moment too soon, they caught the full force of the downside. Their funds tumbled by an astonishing average of 70 per-cent during the next three years. Result: While the funds themselves achieved a net gain of 13 percent, the investors in these funds incurred a loss of 57 percent. By investing in these once high-flying funds, more than half of the capital that investors had placed in these hot funds had gone up in smoke. The message is clear: avoid performance chasing based on short-term returns, especially during great bull markets.

EXHIBIT 9.2 Picking the Short-Term Winners: Cumulative Returns, 1997-2002

Though the results are hardly as dramatic, the “don’t chase past performance” principle also holds during more sedate stock markets. In my first book, Bogle on Mutual Funds, I compared the records of the 20 top-performing mutual funds during each year from 1982 through 1992 with their records in the subsequent year (Exhibit 9.3). As it happened, the top 20 funds of that ranked number one in each year had a subsequent average ranking of 284 among the list of 681 funds, outpacing 58 percent of their peers, or barely above average. During that period, the highest achievement on the 20-fund list was turned in by the number one funds, which averaged a rank of 100 in the subsequent year.

EXHIBIT 9.3 Reversion to the Mean: Top 20 Funds, 1982-1992 and 1995-2005

The clear reversion to the mean suggested by that single test represented powerful evidence that winning performance by a mutual fund is unlikely to be repeated. But there was no reason (except common sense) to assume that the 1982 to 1992 experience would recur. So, just for fun, I repeated the test in 2006, beginning with the top-performing 20 funds in 1995 and the top 20 funds in each of the nine subsequent years. I then checked the rank of each fund in the following year, just as before.

In general, the results were remarkably similar. The average subsequent rank of the top 20 funds from 1995 through 2005 was 619, outpacing 57 percent of their peers and barely above the average fund among the 1,440 fund total—just as in the prior test. In an interesting reversal of fortune, however, the number one funds of that era turned out to have, not the highest subsequent ranking, but the lowest ranking among the top 20. These champions subsequently earned an average ranking of 949 among the 1,440-fund total, outpacing only 34 percent of their peers. While “the first can be first” sometimes, the first can be last at other times, a wonderful illustration of the inevitable randomness of fund performance.

The stars produced in the mutual fund field are rarely stars; all too often they are comets.

The message is clear: reversion to the mean (RTM)—in this case, the tendency of funds whose records substantially exceed industry norms to return to average or below—is alive and well in the mutual fund industry. In stock market blow-offs, “the first shall be last.” But in more typical environments, reversion to the fund mean—which, as we have seen in earlier chapters, substantially lags the return earned by a stock market index fund—is the rule. So please remember that the stars produced in the mutual fund field are rarely stars; all too often they are comets, lighting up the firmament for a brief moment in time and then flaming out, their ashes floating gently to earth.

With each passing year, the reality is increasingly clear. Fund returns seem to be random. Yes, there are rare cases where skill seems to be involved, but it would require decades to determine how much of a fund’s success can be attributed to luck, and how much attributed to skill. And by then, you might ask yourself questions like these: (1) How long will that manager, with that staff and with that strategy, remain on the job? (2) If the fund’s assets are many times larger at the end of the period than at the beginning, will the same results that were attractive in the first place be sustained? (3) Will the stock market continue to favor the same kinds of stocks that have been at the heart of the manager’s style? In short, selecting mutual funds on the basis of short-term performance is all too likely to be hazardous duty, and it is almost always destined to produce returns that fall far short of those achieved by the stock market, itself so easily achievable through an index fund.

Don’t Take My Word for It

Listen to Nassim Nicholas Taleb, author of Fooled by Randomness: “Toss a coin; heads and the manager will make $10,000 over the year, tails and he will lose $10,000. We run [the contest] for the first year [for 10,000 managers]. At the end of the year, we expect 5,000 managers to be up $10,000 each, and 5,000 to be down $10,000. Now we run the game a second year. Again, we can expect 2,500 managers to be up two years in a row; another year, 1,250; a fourth one, 625; a fifth, 313. We have now, simply in a fair game, 313 managers who made money for five years in a row. [And in 10 years, just 10 of the original 10,000 managers.] Out of pure luck. . . . A population entirely composed of bad managers will produce a small amount of great track records. . . . The number of managers with great track records in a given market depends far more on the number of people who started in the investment business (in place of going to dental school), rather than on their ability to produce profits.”

That may sound theoretical, so here is a practical outlook. Hear Money magazine’s colloquy with Ted Aronson, partner of respected Philadelphia money management firm Aronson+Johnson+Ortiz:

Q. You’ve said that investing in an actively managed fund (as opposed to a passively run index fund) is an act of faith. What do you mean?

A. Under normal circumstances, it takes between 20 and 800 years [of monitoring performance] to statistically prove that a money manager is skillful, not lucky. To be 95 percent certain that a manager is not just lucky, it can easily take nearly a millennium—which is a lot more than most people have in mind when they say “long-term.” Even to be only 75 percent sure he’s skillful, you’d generally have to track a manager’s performance for between 16 and 115 years. . . . Investors need to know how the money management business really works. It’s a stacked deck. The game is unfair.

Q. Where do you invest?

A. In Vanguard index funds. I’ve owned Vanguard Index 500 for 23 years. Once you throw in taxes, it just skewers the argument for active management. Personally, I think indexing wins hands-down. After tax, active management just can’t win.”

Finally, Money magazine columnist and author Jason Zweig sums up performance chasing in a single pungent sentence: “Buying funds based purely on their past performance is one of the stupidest things an investor can do.”