Over the long haul, the stock market's outperformance over cash boils down to just a few critical months. Miss those months and you will have missed all the risk premium to be earned from holding a volatile asset such as stocks.
Between January 1926 and October 2018, U.S. large-cap stocks owed their outperformance over cash to just 51 months—less than 5% of the months in the sample. If you held stocks for all 1,063 months apart from those 51 months, which we will call "critical months," a term which we will define more precisely below, you would not have beaten cash.
This is not just a U.S. phenomenon. In a recent article, I documented that since 1956 the Canadian stock market owed its outperformance to only 69 best-months, or 9% of all months considered.[i]
The obvious implication of these findings is that it is exceedingly hazardous to try to time markets. Staying invested is the name of the game.
In the recent equity research report “Is There A ‘Good’ Time to Buy or Sell Actively Managed Funds?” we applied an analytical approach to active management with this question: For an actively managed fund that outperformed its benchmark over a given time period, how many critical months accounted for that outperformance?
We find that, on average, less than 5% of the months account for all of the outperformance. Active management turns out to follow the same dynamic as the market as a whole. It is thus natural that the implications for buying and selling actively managed funds should be similar to those regarding timing entire markets.
How we did it
Critical months are those months whose removal from the return series would eliminate the fund's outperformance over its benchmark.
We find this by calculating geometric excess return of a fund over its index for all months. Geometric excess returns are multiplicative, so that the geometric excess return over the whole period is the product of all the months' excess returns, so we remove, one by one, the month with the highest excess returns, the second-highest excess return, and so on until no excess return over the whole period remains.
To see what actively managed funds look like from the critical-months perspective, we conducted a global study that used active funds' returns over the 15-year period from Nov. 1, 2003, through Oct. 31, 2018. There is nothing special about using this particular 15-year period: It was a long enough time frame to measure long-term performance, and it gave us a sizable sample of funds. We used the following criteria to select funds and their appropriate indexes:
- To remove the effect of fund fees, which vary across regions, we used gross returns.
- Fund domiciles included the United States, Canada, the United Kingdom, the eurozone, Europe ex-euro, and developed Asia ex-Japan. Japan and Australia were not included because of the difficulty of obtaining gross returns for those markets.
- We used the oldest share class for each fund.
- There must be 180 monthly total returns over the period from November 2003 to October 2018. Consequently, the study omits the results of funds that began the 15-year period but did not finish it because they were merged away or liquidated before October 2018. This choice was motivated by the desire to have all returns for all funds over the time period.
- In some regions, funds are offered in hedged and unhedged versions, and in local as well as foreign currencies, so we used only unhedged share classes.
- For each month, a fund's historical categorization (its Morningstar Category) was used to assign the fund's benchmark. The reason for this was that funds change behavior and mandates, which may result in their recategorization. By matching an index appropriate to a fund's category at every point in time we avoided the risk of comparing a fund's return to an irrelevant benchmark.
- For the U.S., we mapped each category to an appropriate category index. Outside of the U.S., we used its primary index.
- Because the primary index is sometimes denominated in a currency that differs from the fund's own currency, we translated all the funds' and indexes' returns into U.S. dollars.
- We used only equity funds. We excluded fixed-income and allocation funds because they are sometimes harder to map to an appropriate index.
Applying these criteria gave us 5,568 unique fund and fund-category-adjusted-index histories that were used to calculate the funds' critical months. We focused our attention on the 3,753 of these funds that outperformed their benchmarks.
Results
Exhibits 2 and 3 aggregate statistics for critical months, first in aggregate and then grouped by region. One can immediately see that whether it's mean, median, or the top- and bottom-quartile breakdowns, these numbers are small and should give little comfort to investors who try to find the best times to buy and sell actively managed funds. In aggregate, the median number of critical months was six. That means that half of the funds' outperformance was due to six or fewer months. One in four months (25th percentile) owed their outperformance to three or fewer months. Finally, three fourths (75th percentile) of all the funds' outperformance was attributable to 10 or fewer months. These statistics don't vary much among regions.
Finally, we divided funds by deciles of outperformance and show, in Exhibit 5, how many critical months, on average, each decile had. Even the best decile of outperforming funds, on average, owed their outperformance to just 16 months of excess returns. That is one year and four months out of 15 years.
Summary
In our purely descriptive account of outperformance, we remain agnostic as to what the exact distribution of excess returns is. There is solid evidence that most actively managed funds' excess returns are not normally distributed. But from our perspective the exact shape of that distribution does not matter.
What matters—and this is the most practical implication of our findings—is that trying to find the best time to buy or sell a fund is most likely futile. Most of the time, even outperforming funds basically track or trail the index.
If you think you have identified a skilled manager, the best course of action is to buy in or dollar-cost average, regardless of the moment, and hold on to him or her over long periods of time.
The obvious, and perhaps even more important, corollary is that a fair amount of patience is required to adhere to such a program. A good manager may take a long time before critical months materialize. Thus, don't sell based on the “what have you done for me lately” rationale. The gospel of wisdom can be adapted to active management: No one knows the day or the hour when outperformance will strike.
[i] Kaplan, Paul D. 2018. "The Best of Times and the Worst of Times." Moringstar.ca, 10 December.
