Evaluate the historical investment performance of mutual funds and ETFs, but only AFTER using other screening criteria
Choosing only from among mutual funds and ETFs that have performed very well in the past can lead to significant selection mistakes and inferior personal portfolio returns.
Previous superior or average fund performance simply does not predict similar fund performance in the future. However, there is modest evidence that substantially inferior past fund performance is more likely to lead to continued inferior performance in the future, which is probably due to the excess costs of substantially inferior funds.
The primary objective of using scientifically grounded screening criteria is to identify funds for more careful evaluation, which have higher chances of performing better in the future on both a sustained and risk-adjusted basis. As a first step in their screening process, many investors instinctively start by sorting funds on the basis their superior historical performance. They want to choose only from among funds that have performed the best in the past. They hope that superior past performance will continue into the future. This approach is flawed, and it can lead to selection fund mistakes, higher costs, and inferior investment results. (See for example: What might be wrong with buying a mutual fund with a 4 or 5 star Morningstar Rating?)
The evidence from investment studies indicates that superior past performance simply does not indicate superior future performance.
When historical mutual fund performance is evaluated carefully in well-designed statistical studies, there is little evidence that managers of funds with superior past performance will sustain this performance into the future. (ETFs are too new to have a similar body of historical research, but the substantial similarities between mutual funds and ETFs make contrary findings unlikely.)
Past fund success is simply not an indicator of future success.1 In fact, superior past fund performance seems not to indicate any more than the likelihood that a fund is likely to have average performance in the future. Funds that recently demonstrated average performance are likely also to have average performance into the future. Previously superior or average fund performance does not predict similar future performance. Some average and some superior performing funds in the past will be average in the future and some will do better or worse than the average.
However, there is modest evidence that substantially inferior past fund performance is more likely to lead to continued inferior performance in the future. Significant past failure is a mild indicator of future failure. (See: Do Morningstar Ratings predict risk-adjusted equity mutual fund performance?)
Given that big past losers have a mild tendency to keep losing, but past winners are likely to be average in the future, these findings would change significantly how one should use historical performance indicators. Instead of starting by selecting only the best past performers, The Skilled Investor believes that investors are better served by first applying other much more useful fund selection criteria. The Skilled Investor discusses these primary criteria in other articles:
- Rational selection of bond and equity mutual funds and ETFs -- overview
- Choose mutual funds and ETFs with lower investment management expenses
- Avoid mutual funds and ETFs with higher investment portfolio turnover
- Avoid mutual funds and ETFs with sales commissions and 12b-1 fees
- Avoid very large actively managed mutual funds and ETFs
- Choose sufficiently mature mutual funds and ETFs
- Choose mutual funds and ETFs with a minimum economical portfolio size
This list of screening criteria should been applied first to narrow down the number of funds under consideration. Only then, should the investor use historical performance measures to evaluate his screened list and only with the sole objective of eliminating those funds that have had a history of sustained and significant underperformance. The investor can then use the web and other sources to research in greater depth the remaining funds on the screened list – whether or not their prior performance has been average or superior.
1) Mark M. Carhart “On Persistence in Mutual Fund Performance.” The Journal of Finance, 1997, Vol. LII, No. 1: pp 57-82