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Investing

Time to Stop Loving That “Hot” Portfolio Manager

…and by “hot” I’m not referring to looks.

Rather, I’m referring to a portfolio manager who is having a hot streak of outperformance.

The fact is, manager outperformance is not persistent and it is not a predictor of future outperformance. Indeed, most portfolio managers see their hot streak come to an abrupt end within a year. Almost all meet their demise within two years.

The lack of outperformance persistence suggests any hot streak is the result of luck and not skill. Therefore, the active management fees charged by portfolio managers are not worth paying. Investors would be better off using low cost index funds.

This is all based on research performed by Standard and Poors:

For funds categorized as top performers in September 2017, 47% maintained their top-quartile performance the subsequent year. However, there was a dramatic fall in persistence afterward—just 8% of domestic equity funds remained in the top quartile in the three-year period ending September 2019. This result (8%) is consistent with the notion that historical performance is only randomly associated with future performance.

They continue…

An inverse relationship exists between the time horizon length and the ability of top performing funds to maintain their success. Less than 3% of equity funds in all categories maintained their top-quartile status at the end of the five-year measurement period. In fact, no large-cap fund was able to consistently deliver top-quartile performance by the end of the fifth year.

What about poorly performing fourth quartile funds? Could they experience a swing into outperformance territory in subsequent periods? Unfortunately not.

Fourth-quartile funds were most likely to be merged or liquidated across categories over the five-year horizon. This supports the view that underperformance typically precedes a fund’s closure.

Yet another nail in the coffin for active managers and the exorbitant fees they charge. You’re clearly better off ditching that hot portfolio manager for a portfolio of low cost index funds.

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