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Don’t pick outperforming funds if you want a good return

Fund selectors would not do wise using past performance as a metric in their fund selection process, according to three American scholars. Moreover, funds that have outperformed their benchmark over the past three years tend to underperform funds with a mediocre or poor performance record over the next three year-period.

The power of momentum

So why could it be that winning funds turn into losers and vice versa? The authors suggest this could have something to do with momentum on the fund level. “Our argument is related to Woolley and Vayanos’ [2012] Theory of Asset Mispricing. They show that performance-chasing flows will create short-term momentum in the performance of winner managers but also reversal when the flows reverse out to chase the next winner strategy a few quarters hence.[2]”

ource ravis eister

The study risks being affected by survivorship bias since underperforming funds are more likely to be shut down than their well-performing equivalents. The authors control for this by using the Morningstar Direct survivor-bias-free United States Mutual Funds Database. They do not, however, control for sector exposure, which is a major driver of returns for equity funds. Differences in sector exposure could possibly explain some of the discrepancy in returns between the ‘winner’ and ‘loser’ portfolios, but probably not all of it.

However powerful their results are, the authors are under no illusions that investors will prefer poorly performing funds over well-performing ones after reading their paper. “Despite our findings, a policy of firing successful managers and replacing them with poor performers is not likely to gain widespread acceptance,” they acknowledge[3].

Instead, they suggest fund selectors should instead focus on metrics that are better predictors of performance, such as the investment strategy of a fund, manager ownership, active share and total fund fees.

[2] Does past performance matter in investment manager selection?Brad Cornell, Jason Hsu & David Nanigian (2016)

[3] Does past performance matter in investment manager selection?Brad Cornell, Jason Hsu & David Nanigian (2016)

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