Fuhr: the shooting stars of active management often fall hardest
The performance of active fund managers is like the path of a meteor entering the Earth’s atmosphere, according to a new study from Standard and Poor’s Indices.
These funds are initially called shooting stars, but their glory is often short-lived.
In 2011, for example, 81% of active large-cap managers underperformed the S&P 500, according to the S&P Indices Versus Active Funds report. Even changing the look-back period of the asset class makes little difference to the results.
S&P has also just published the Persistence Scorecard – a semi-annual companion report that compares funds to each other, rather than to indexes – by asking whether a fund that was above average in year one is still above average in years two to five.
Very few funds manage to repeat top-half or top-quartile performance consistently.
Given the volatility in the domestic equity markets over the last five years, it is unsurprising that data for the period ending March 2012 shows the percentage of top-performing managers remaining in the top-half or top-quartile declined considerably in several categories.
For the five years ending March 2012, only 5.23% of large-cap funds, 5.46% of mid-cap funds and 5.14% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Random expectations would suggest a rate of 6.25%.
Looking at longer-term performance, 5.97% of large-cap funds with a top-quartile ranking over the five years ending March 2007 maintained a top-quartile position over the next five years.
Only 4.35% of mid-cap funds and 15.56% of small-cap funds maintained a top-quartile performance over the same period. Random expectations would suggest a repeat rate of 25%.
While top-quartile and top-half repeat rates have been at or below the levels one expects based on chance, there is consistency in the death rate of bottom-quartile funds, across all market cap categories.
Chart one below illustrates the ability of winning managers in each size category to consistently maintain top half performance for five consecutive years. There are only four years shown as all managers tracked were in the top half in year one.
S&P found the ‘death rate’ or number of fund closures through liquidations and mergers is about 5% per year, as illustrated in chart two. This rate has been consistent since 2000.
The death rate is higher among the bottom-half performers than the top-half performers, and it is almost 40% for the bottom-quartile funds. Funds with poor performance are most likely to be liquidated or merged.
The scorecard illustrates how difficult it is for past winning managers to win again in the future, and why as investors we should read and heed the disclaimer found on most mutual fund literature that ‘past performance is not an indicator of future outcomes’.
The perils of past performance
Given these facts, it is surprising how many investors and advisers consider past performance and related metrics to be important factors in fund selection.
The message for investors is that past performance is not a good indicator of future performance for active funds and there are a small handful of managers – typically less than 6% – who consistently deliver top-quartile performance, but it is very challenging to find them.
The challenge of finding good active managers is one of the reasons that index funds and exchange traded funds are often better solutions for both retail and institutional investors.