Is a mutual fund’s past performance a reliable guide for estimating future returns?

Because investors are trying to make important investment decisions without a crystal ball, they look for mental anchors to provide a basis for their decisions. One of our most common mental anchors is to take past outcomes and project them forward into the future. However, history shows that this process, by itself, is not a great tool for making investment decisions.

In a recent paper, Standard and Poors Research (January, 2010) examined the success of using a mutual fund’s past performance as an indicator of future investment outcomes. (See the Mutual Fund section for a copy of this report.) 

They conclude in their research that “screening for top-quartile funds may be inappropriate.” But they note, “Screening out bottom quartile funds may be appropriate, however, since they have a very high probability of being merged or liquidated.”

Their research, which accounted for Survivorship Bias, found that very few funds managed to consistently repeat top-half or top-quartile performance. Over the five years ending September, 2009, only 4.27% of Large-Cap funds, 3.98% of Mid-Cap funds and 9.13 Small-Cap funds maintained a Top-Half ranking over five consecutive 12-month periods.

No Large-Cap, Mid-Cap funds, and only one Small-Cap fund, maintained a Top-Quartile ranking over the same period.

Statistically speaking, these results are even below the expected probability rates. They state that if fund returns “are random and independent of prior returns, one would expect the top-half repeat rate to be 6.25% and the top-quartile repeat rate to be 0.39%.”

In conclusion, their paper suggests that, as all mutual fund companies state, past performance does not represent future performance. So where does that leave you when trying to choose a mutual fund to invest in?  Unfortunately, the answer would seem that there is no one particular easy method to value and select mutual funds.

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