The number one gimmick investment fund marketers use to sell their products is a strong performance track record. Historical performance is considered a staple piece of information by fund marketers and unitholders, as it makes the product appear more tangible.
Unfortunately, historical performance is useless when evaluating a fund.
You’ve probably seen the following disclaimer along in most investment funds marketing:
“Historical performance are not indicative of expected future returns and may not be repeated.”
This disclaimer is there for a reason. It is added to marketing materials because the regulators know that funds are sold based on historical returns, so they want it to be clear that past performance has nothing to do with future performance.
Even if all aspects of the fund – the manager, the style, the investment policy guidelines – remain the same, the vast majority of strong performance is fleeting in nature and cannot be repeated. Managers can get lucky streaks that result in periods of outperformance. However, few have genuine skill and are unable to repeat this outperformance consistently.
The empirical evidence supports this.
In its report called “Persistence Scorecard”, Standard and Poors regularly provides data on the persistence of investment manager outperformance. On July 15, 2020, for the first time, S&P has calculated this for the Canadian market.
The Persistence Scorecard attempts to distinguish luck from skill by measuring the consistency of active managers’ success. The inaugural Canada Persistence Scorecard shows that, regardless of asset class or style focus, few Canadian fund managers have consistently outperformed their peers.
For example, across all seven categories we track, none of the equity funds in their category’s top quartile in 2015 maintained that status annually through 2019. If we consider funds in the top half of 2015’s performance distribution, in six of the seven categories fewer than 5% of funds maintained their performance over the next four years. Coin flippers had higher odds of success.
In general, very few Canadian investment managers have demonstrated that periods of outperformance were due to skill and could be repeated.
Lengthening the horizon to consider performance over two consecutive five-year periods, the top-quartile domestic equity funds of 2010-2014 had little luck maintaining their top-quartile status during the 2015-2019 period. Only 30% of them managed to beat the median while 23% ended up in liquidation or had a style change.
While there may be a handful of investment managers that possess the skill to consistently outperform the market, it is impossible to identify these people in advance. The evidence shows that the vast majority of investment managers cannot repeat periods of outperformance. Yet these active investment managers charge 2.5% for the pleasure of their underperformance.
Consequently, investors would do much better by using low cost index funds and instead focusing on managing their investing behaviour, savings rate, debt, taxes and asset allocation.