I’m going to tell you something Wall Street really doesn’t want you to know.

Past stellar performance of an actively managed mutual fund doesn’t predict future performance.  But the real story is much more interesting.  There may be a way to select outperforming mutual funds based on past performance, but it’s not what you think.

A recently published study in The Journal of Portfolio Management examines the role of past performance in predicting future performance.   Before delving into its surprising findings, let’s place this issue in context.

Wall Street misleads you

Here’s a sampling of recent ads by the mutual fund industry, trolling for your assets:

• Five American Funds that Beat the First Index Fund’s Lifetime Results.
• Steady Mutual Funds That Beat the S&P 500.
• 5 Funds That Crush The S&P 500 And Pay 9.3% Dividends.

The message in these posts is clear:  We did it before and we can do it again.

Here’s how the author of one article justified his selection of funds likely to outperform in the future:  The truth is, there are literally hundreds of funds out there that have been outperforming the market for a long time. Today, I’m going to show you five of them.

Anyone can look at data and tell you what funds have outperformed in the past.  That information will only benefit you if the outperformance is likely to persist in the future.

Debunking the myth

Institutions generally won’t invest in mutual funds with less than $1 billion in assets.  The study looked at all mutual funds in the Morningstar database from 1994-2015.  They eliminated funds with the highest expenses.

The way institutions select mutual funds for their portfolios follows a predictable pattern.  They often use a consultant who helps them select funds for inclusion, relying on past performance.  When those funds stop performing well, the consultant typically recommends the institution “fire” those funds and replace them with funds that have superior recent performance over the prior three-year period.

The results of the study were both startling and counter-intuitive.

The authors found that funds that which underperformed their benchmarks by 1% and 3% —causing them to be “fired”—outperformed funds that were kept.

Based on this research, institutions and individuals would be well advised to ignore mutual funds with great track records and buy “loser” funds instead.

Other studies have demonstrated that most investors would be well served by not buying any actively managed fund, regardless of its track record.  The odds against picking an outperforming, actively managed fund prospectively are daunting.

One study found that, for the period 2007-2016, an average of only 27% of top five-year performers ranked in the top quartile of annual performance the following year.  Most “winners” turned into “losers.”

The same study showed high costs and excessive turnover — both of which are present in most actively managed funds — contribute to the likelihood of underperformance.

Relying on a mutual fund’s past performance as an indicator of future performance is the biggest myth in investing.  Don’t believe it.

Resource of the Week

This white paper from Vanguard discusses the impact in performance evaluation of accounting for mutual funds that closed.  Failure to do so can artificially inflate the performance of surviving funds.

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