By Sam Mamudi
A DOW JONES COLUMN
It's perhaps the most quoted financial-services mantra: Past performance is no indication of future results.
Unfortunately, human nature usually leads investors to think the exact opposite.
Most investors look at a fund manager's returns before deciding to invest. The question is: Just how much can we judge a fund by its track record?
Several studies published last year suggest that picking a fund based on its past is far from a sure thing. Among other findings, the studies show that fund ratings don't help identify future performance, that it's difficult to distinguish a manager's skill from luck, and that for all but the very top funds, future performance is unlikely to meet expectations.
In other words, it's a messy and largely unpredictable business. But that doesn't stop investors from choosing their funds based purely on track record.
"When you look at the data, there's a pretty slight and often infrequent relationship between past and future performance, and yet people still put an awful lot of stock in a fund's performance," said John Rekenthaler, vice president of research at Morningstar Inc. "In their hearts, most people believe that it works."
Top Dogs Fall Down
Advisor Perspectives, an e-newsletter for financial advisers, in December published a study which suggests that Morningstar Inc.'s star ratings, which are based on past returns, don't provide much predictive value. It also found that many five-star-rated funds were likely to underperform their peers.
Robert Huebscher, chief executive of Advisor Perspectives, randomly selected a fund with a particular rating, and then looked at how that fund performed against randomly selected funds with lower-star ratings from the third quarter of 2006 through the third quarter of 2009. He found many cases where the lower-rated funds were more likely to outperform those with higher ratings.
Yet, despite those findings, "the public pour money into funds that get higher ratings," Huebscher said.
Part of the problem is how fund companies sell themselves, he said. "The most concrete thing a fund can sell is its historical performance, so they say, 'We did well in the past and you should think that we'll do well in the future.' "
Matthew Morey, professor of finance at Pace University's Lubin School of Business, conducted several studies on the predictive value of Morningstar ratings. He took issue with some of Huebscher's methodology, particularly the way it lumps all mutual funds into five broad categories--U.S. stock, international stock, taxable bond, balanced and municipal bond--and compares funds within these broad categories. That doesn't account for the variety of approaches that funds take, he said.
A better method, Morey said, would be to look at funds' relative performance within each of Morningstar's 48 categories. And, he said, Huebscher's study acknowledges that it doesn't include funds that were liquidated or merged away during the period--a fact that likely boosts the performance of the worst funds, since it's rare for a four- or five-star fund to close.
Morningstar's Rekenthaler questioned the time frame the study used. But while he disagreed with some of the details, he said he didn't have an issue with the notion that it's hard to use past performance to predict future results.
Luck Versus Skill
Morey said there's a case to be made that top managers can repeat their performance.
"I do think good managers, who've been at a fund a long time, produced consistently good performance and charge relatively low fees are a good way to go," he said.
Morey added that about 10 years ago he was a firm believer in index funds, but has recently come around to the idea that there are some good managers out there.
A Morgan Stanley Smith Barney's Consulting Group study seems to support that view. The study found that the very best managers-- the top 10%--can repeat their performance; at least, they did in three-year periods from 1994 to 2007 covered in the study. But the study also found that the worst 20% of performers are also likely to outperform in the future.
The study's author, Frank Nickel, said this is because the bottom funds benefit from changing market cycles--their holdings were out of favor but then get hot and thus outperform. Nickel said that rather than picking a fund based on manager ability--which his study suggests does exist--he'd rather pick an unloved area of the market and ride its moves to the top.
"I like buying things that are out of favor because they're likely to be cheap," Nickel said in an interview. In other words he thinks a surer way to pick funds is by market cycles rather than manager, even a good manager.
Nickel, as well as Pace University's Morey, said that even funds with good managers may not be wise investments in the future. That's because the popularity of successful funds means over long periods of time they often grow so big that their managers can't repeat their performance: The large number of assets in the fund makes it too hard to put all that money to effective use.
But while Nickel was willing to ascribe some outperformance to manager skill, some researchers dispute even that claim.
A study published late last year by Eugene Fama, professor of finance at the University of Chicago Booth School of Business, and Kenneth French, professor of finance at Dartmouth College Tuck School of Business, ran 10,000 simulations of what investors could expect from actively managed funds. They found that outside the top 3% of funds, active management lags results that would be delivered due simply to chance. In other words, aside from the top 3%, there's no way of knowing whether performance is based on luck or skill.
Fama is one of the pioneers of the efficient-market hypothesis-- the idea that securities are priced correctly because they incorporate all the known information relating to a company--and so it fits his views to suggest that very few people can consistently beat the financial markets. But that doesn't lessen the relevance of his research. Nickel said that, while he hasn't seen Fama and French's study, it's possible that the consistency his study found among the top 10% of funds were delivered by the top 3% of managers who could be said to have skill.
Less Efficient Markets
Morey said markets have become less efficient in the past 10 to 15 years, thus creating an opportunity for good managers. He pointed to increasingly unclear company accounts, the fact that derivatives positions aren't fully reported and the recent failures of the bond-ratings agencies as examples of how hard it's become for investors to get full information about companies.
"We're more in the dark now than we were 20 years ago," he said. In such a world, a good manager can make a difference, he added.
Morey named T. Rowe Price Group Inc. (TROW) as an example of a firm with good managers. It's not just about performance, but the fact that T. Rowe seems to encourage and develop its managers, who typically stay for many years.
"There's definitely a 'T. Rowe culture,' " said Rekenthaler, echoing Morey's sentiments.
Rekenthaler said he'd also include American Funds, a unit of Capital Group Cos., and Vanguard Group as fund companies that seem to have the right culture--not just in manager development, but by charging relatively low fees and having fairly conservative fund strategies, as well as not launching funds in popular sectors just to grow assets.
"I've moved in my thinking from being enamored with a fund to liking a fund company," he said. "You need to surround yourself with the best-quality of people."
So will investors look more at a fund firm's culture rather than a top performing manager? Fund flows suggest it's unlikely.
"It's what we call the hot-hand fallacy," said Hersh Shefrin, professor of finance at Santa Clara University's Leavey School of Business, and a pioneer in the field of behavioral finance.
Think about watching a basketball game. If a player hits several baskets in a row, we think he's hot, that he's more likely to make his next shot. But statistics show that a player who's made his recent buckets isn't more likely to make his next one.
"Our intuition is misguided," said Shefrin. "If we don't know the odds and try to estimate them we tend to overweight recent events."
Instead of taking a chance on an unpredictable fund manager, Shefrin suggested investors review their entire approach.
"There are two needs we're talking about here, financial and psychological," he said. "For your financial needs the best long-term approach is buy-and-hold with a well-diversified set of securities with [passive] bond and stock holdings that reflect your risk profile.
"For your psychological needs--and we're all thrill-seekers-- just recognize it for what it is and protect yourself," Shefrin said. "Treat your [hot stock] choices the way you would if you went to Las Vegas--you don't go expecting to make money."
(Sam Mamudi writes for MarketWatch. He can be reached at 415-439-6400 or by email at: AskNewswires@dowjones.com)