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Why you shouldn’t pick mutual funds based on past performance

Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can view his model portfolio here and read more in the series online here.

In 1998, my friend Linda invested money in the Sprott Canadian Equity Fund. Between 1999 and 2006, she averaged, net of fees, about 35 per cent per year. The fund had another strong year in 2007. It dropped just over 40 per cent in 2008. But it roared back in 2009 and 2010, gaining 36 per cent and 57.6 per cent.

It's instinctive. We often pick funds based entirely on their track records. But we shouldn't. In 2010, Linda read The Little Book of Common Sense Investing. Author John Bogle said that some funds do beat the market. And those are the funds that investors flock to. Most winning funds, however, lose their market-beating mojo. So Mr. Bogle says most investors should buy index funds instead.

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After reading Mr. Bogle's book, Linda sold her shares in the Sprott Canadian Equity Fund. She couldn't have been luckier. Like the Incredible Hulk morphing back into his alter ego, Bruce Banner, the fund began to atrophy. In the five years ended March 31, 2015, the Sprott Canadian Equity Fund plunged nearly 35 per cent. At the same time, the S&P/TSX composite index gained 43 per cent.

William Bernstein is the author of five investment books. They include The Four Pillars of Investing and The Investor's Manifesto. He says that funds with strong track records don't usually continue their winning ways. "Three things account for the relative performance of investment managers: skill, exposure to easily identifiable portfolio characteristics like median company size and valuation, and dumb luck. The last two factors, which are random, are far more important than the first, and in such a world, manager outperformance shouldn't persist."

He points to mutual fund data collected by Micropal Group Ltd. It identified the top-performing U.S. mutual funds over five-year periods, starting in 1970. Then it tracked those top-performing funds to see how they performed between then and 1998.

For example, the top-performing 30 funds between 1970 and 1974 beat the S&P 500. But in the years that followed, they didn't. Between 1975 and 1998, the funds averaged 16.1 per cent. The index averaged 17 per cent.

Because most didn't continue to beat the market, there was a new batch of top-30 funds between 1975 and 1979. The new top 30 beat the market – until they didn't. They averaged 15.8 per cent from 1980 to 1998. The S&P 500 averaged 17.7 per cent.

From 1980 to 1984, 1985 to 1989, 1990 to 1994, and from 1995 until the end of the study, Micropal found similar results. On average, the 30 funds with the best five-year track records couldn't keep beating the index long term.

Keith Loggie, senior director of global research and design at S&P Dow Jones Indices, says, "It is very difficult for active fund managers to consistently outperform their peers.… There is no evidence that a fund that outperforms in one period, or even over several consecutive periods, has any greater likelihood than other funds of outperforming in the future."

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Twice a year, S&P Dow Jones Indices publishes the Persistence Scorecard. Their data also show that funds with strong track records rarely keep winning. Their 2014 Scorecard evaluated 687 U.S. mutual funds that were in the top quartile of performers as of March, 2012. By the end of March, 2014, just 3.8 per cent of the funds managed to remain in the top 25 per cent.

Just 1.9 per cent of the large-cap funds, 3.2 per cent of the mid-cap funds and 4.1 per cent of the small-cap funds remained among the top quartile.

S&P's Persistence Scorecard data also show that fortunes can reverse. Of 426 funds that were in the bottom quartile in 2009, 28.64 per cent moved to the top quartile over a five-year horizon, while 28.57 per cent of those top-quartile funds moved into the bottom quartile during the same period. But why don't winning funds continue to win?

Mr. Bernstein says much of performance comes down to luck. Jason Zweig offers a different theory. He updated Benjamin Graham's iconic book, The Intelligent Investor. Mr. Zweig says investors flock to winning funds, increasing their asset sizes. The larger a fund gets, the tougher it is to beat the market. It's less nimble. Fund managers then have a tougher time moving in and out of positions. When the manager discovers a great, underpriced stock, its growth also has less of an impact on a larger fund than it would have had when the fund was small.

So how do you pick a mutual fund? Morningstar says that a fund's management expense ratio – what it costs an investment company to operate the fund – is the best predictor of future performance: the lower, the better. So don't get led astray by a fund's past results.

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