I often refer people who continue to believe in active management to Standard and Poor’s semi-annual SPIVA studies that show very clearly how the vast majority of active managers consistently underperform their relevant benchmarks across asset classes and time periods. S&P publishes a companion study that is just as remarkable and I’d like to bring it to your attention in this post. It’s called the S&P Persistence Scorecard and it focuses on the topic of just how relevant past performance is in predicting future performance.
As trite as the phrase “past performance is no predictor of future performance” is, investors and advisors alike tend to select active managers based almost entirely on past performance. To some degree, it makes perfect sense to pick managers this way. Why would anyone select a fund that was among the worst performers over the last five years? We all like to go with a proven winner, and mutual fund investing follows the same logic. However, the Persistence Scorecard shows just how big a mistake this seemingly intuitive approach to manager selection can be.
In the most recent study (November 2010), it shows that of the 155 domestic large cap mutual funds that were ranked in the top quartile of their category for the year ending in September 2005, only 14.2% were still in the top quartile five years later (statistically we would expect 25% to remain in the top quartile after a fifth year). If we broaden the universe to the top half of large cap mutual funds (310 funds), only 32.6% – less than a third of them, were able to maintain their position in the top half of large cap mutual funds at the end of five years! These results are relatively similar for domestic mid- and small-cap funds, too.
It is no wonder that investors and their advisors tend to chase their own tails as they try to create portfolios with “best of breed” money managers. All they end up doing is running from one fund to the next as each fund they choose tends to migrate lower in the rankings over time. They get into the fund after it has done well, only to see it begin to underperform while they are invested in it, and practically every investor and advisor continues to make this mistake over and over and over.
The SPIVA report combined with the Persistence Scorecard should provide enough convincing evidence to investors that continuing to invest by giving your money to various “best of breed” active managers is unlikely to yield the desired results. Much better results can be found by avoiding the active manager decision altogether and focusing on things that actually matter such as asset allocation and long term investment themes. Use passive investments to wisely allocate your portfolio across various markets and asset classes after considering historical relationships among them, risks in the current environment, and expected long term themes for global economic and market expansion. By denying active managers your business, you cut your investment costs considerably and create a structurally tax-efficient portfolio that has a much better chance of meeting your investment needs and expectations. A new frontier for investors has finally evolved, and those who do not consider this better way of investing will eventually regret it.