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Why Can’t ‘Winning’ Active Managers Keep on Winning?

If you’ve read any of my previous articles, you know I’m not a fan of active management. The numbers show that it simply doesn’t work. There are a whole bunch of arguments against active fund managers, but one of the most damning is that winners don’t seem to repeat.

Past performance doesn’t indicate future performance – it’s not just something the killjoy lawyers make everyone say. What someone did in the past doesn’t tell you what they will do going forward (outside of some specific situations).

Individual active managers could potentially beat the market consistently (though it’s tough to identify which ones will beforehand). But this lack of persistent outperformance is the most persuasive argument that active fund managers do not have a widespread ability to beat the market.

If people could beat the market – even if they were just more likely to beat the market than others – this would show up in the persistence data. If someone has actual skill, it doesn’t just go away after a couple of good years, right?

That’s not what the numbers show. It turns out it’s largely random which funds win and which funds don’t.

Winners Don’t Repeat

Let’s look at the data. What we want to see is how often do funds that perform well in one period continue to perform well in the next. Does their good performance persist?

To do this, we can just look at historical returns. Let’s start by defining a well performing fund as one that was in the top 25% of performers in their category over the past 5 years. And then we can see how many of those funds remained in the top 25% of their category over the next 5 years.

At least for stock funds, it’s not pretty.

Past performance is no guarantee of future performance. At the end of each year, funds are sorted within their category based on their five-year total return. The exhibit shows the percentage of funds in the top quartile of five-year performance that ranked in the top quartile of performance over the following five years.

Over the period we’re looking at, from 2008 to 2022, it was slightly less likely than chance that a good performing fund would continue to do well. If it was completely random chance, we would expect 25% of the good performing funds would continue to do well. But over the period we’re looking at only 22% of the good performers continued to do well. And, because we are focusing on the folks who performed well in the initial period, we’re effectively dropping all of the truly awful funds that preclude themselves from decent performance through high expenses and other issues.

Maybe the bond managers are better? Not really. The story is pretty much the same on the bond side of the world.

Past performance is no guarantee of future performance. At the end of each year, funds are sorted within their category based on their five-year total return. The exhibit shows the percentage of funds in the top quartile of five-year performance that ranked in the top quartile of performance over the following five years.

The numbers are slightly better for the bond managers than the stock managers, but not by all that much. And the selection effect from the initial period is even stronger with bonds than it is with stocks. Because bond returns are lower and less volatile fund expenses play a bigger role in the relative performance of bond funds compared to stock funds. If there was skill among the bond managers, I would expect that the group of top performing funds would be substantially more stable than we actually see in the data.

What Does This Tell Us?

It’s one thing to argue that the “average” active manager doesn’t beat the market. That’s almost a mathematical certainty. However, people who buy actively managed funds don’t pick an “average” fund. They pick (what they think is) the best fund out there. They are picking the winners, with the expectation that they will continue to win.

But that’s not what happens. As we’ve seen, it’s basically luck of the draw whether a fund will perform well in the next period. And that’s the period we actually care about. It doesn’t do me any good as an investor if a fund has done well before I put my money in. What matters to me is the returns I get.

Simply put, there are no hot hands in investing.

These are supposed to be the Larry Birds, Michael Jordans, Scottie Pippens, and John Stocktons of fund managers, yet somehow almost two-thirds of them lost that magic touch. That’s not a team I would want to bet on.

To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors.

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