Why funds win: Luck, style and skill
Alex Bryan: If you look over a multi-year period, like most investors do, a lot of investors look at performance over the last five to 10 years as a way of gauging the skill of a manager. But really, if you actually dig into the numbers and look at the performance fund-by-fund within each Morningstar category, there isn’t a strong or at least not a significant relationship between past performance and future performance.
There are a couple of reasons for that. One, performance is a combination of luck, stylistic bets and skill, and it's hard to disentangle all of that information just from past performance. If a manager is in the right place at the right time – let's say they underweighted financials back in 2007 and 2008 – if they are always underweight, financials that can help them in that environment, but it may not necessarily work in other periods, out of sample if you are looking to try to form your expectations going forward.
A lot of times managers are in the right place at the right time stylistically, whether it's overweighting small-cap stocks at the right time or overweighting value or growth stocks at the right time. That may be a permanent bias that a manager has that can influence his performance. And different types of styles come in and out of favour at different times, and it may not be reasonable to expect those different style bets to continue to pay off. So past performance really is a noisy measure when you are looking at skill, which is the one element of past performance you may expect to persist in to the future. You really need to look more holistically to try to gauge what a manager’s skill is, but results of my study have basically found that there is no significant link in most categories between past performance and future performance.
Why funds win: Momentum or management?
Performance often does persist over the very short term. So managers that have outperformed over the past year often continue to do so over the next year. The results of my study have found that’s attributable to differences in their exposure to momentum stocks. For example, managers that have outperformed over the last year have done so because they tend to hold a greater portion of stocks that have outperformed over the last year. No real surprise there.
Managers that have underperformed over the past year tend to hold a disproportionate share of stocks that have underperformed over the last year, because a fund's performance is simply the aggregation of its underlying holdings. And even though managers trade in and out of their positions, most managers by and large continue to hold the same portfolio of stocks more or less in the short term. So it takes them a while to turn over their portfolios on average. And that’s why you see this relative performance continue to persist.
A lot of researchers have documented this momentum effect in individual stocks, where past winners continue to outperform over the short term, and that's true at the fund level too. When you take a portfolio of stocks, you've seen the same type of behaviour. So the results of my study are consistent with results published by others, including Mark Carhart, who first published this momentum effect back in 1997 when he was looking at short-term performance among mutual funds.
Why funds last: Success vs. survival
These results are a bit different than what we found on the performance side. There really isn’t a significant relationship between past and future performance. But if you look at the survivorship rate, there is very much a large difference between the survivorship rates of top past performers and bottom past performers. That gap in the survivorship rates tends to increase over the period of time that you are looking at. So if you are looking at winners over the past 10 years compared to losers over the past 10 years, the difference in their survivorship rates is quite large, and that gap gets smaller if you look over shorter time horizons in the past.
This is actually consistent with our expectations. So funds that have really long track records of outperformance are easier for fund companies to market. And they attract more assets. Investors tend to put money to work in funds with good long-term track records, even though there may not necessarily be a good economic rationale for doing so from an expectation standpoint.
It’s an easier story to sell when you have a good long-term track record. But on the other side of the coin, it’s a lot harder to sell a long track record of underperformance. It becomes harder to explain a way that poor underperformance. And so a lot of those funds tend to close. They are either liquidated or merged into funds with better long term track records. That’s why you see the large differences in survivorship rates between past underperformers and past outperformers.
Morningstar’s Pillars: A holistic approach to funds
Our Morningstar analysts look beyond just past performance to evaluate the merit of investing in each fund. We apply a five-pillar framework that looks at the cost of owning a fund where lower cost can lead to better performance going forward. A lot of studies have found that that’s one of the strongest indicators of future performance.
We look at the process a fund manager applies. So when we look at process, we try to evaluate the standalone merit of the process, but also how well a manager can execute that process. Do they have a competitive edge that may allow them to execute better than their peers?
We also look at the stewardship of the parent company that sells the fund. Is the fund putting its shareholders first? Are they putting their investors first? Are they both capable of executing on the strategy and are they responsible with their fundholders money? So we like to see their large manager investments in the funds that they run, incentives that align manager's interests with fundholders.
We look at past performance to make sure that the fund has performed in the way that we would expect it to in certain market environments. So if we are looking at a more defensive fund, we would expect the outperformance to come during market downturns. And we would be okay if it lagged during stronger environments. It's really the context of the performance that’s the most important thing for analysts evaluating performance.
In addition to that, we look at the people who are running the fund. We look to see how consistent have they been across their other charges. So the other funds that they are managing, again, how much skin in the game do they have? Have they been on the strategy for a long time? Is there a lot of turnover? We like to see funds that are run by experienced managers. They have a lot of investments in their own funds. They have a lot of experience running the strategy.
So those five pillars, we think, provide investors with better odds of finding future outperformers than simply looking at past performance alone.
