Thinking Outside the Box

The Myth of Past Performance

(Excerpts from a Suzan Abboud column written for MoneySense in 2001. The column illustrates a still very popular investment concept known as "reversion to the mean").

If you’ve ever researched which mutual funds to buy, you’ve probably had one thought drummed into your head: always buy top-performing funds. If you’ve read any of the popular mutual fund analysts, you’ve probably seen endless variations on this statement: “Fund XYZ is doing the right things. However, we would not recommend it until we see some improvement in performance.”

No wonder so many of us wind up disappointed with our fund selections. If we followed these experts’ advice, we wouldn’t buy a fund until it had already started to outperform—in other words, when it is already too late, thank you. The fact is that if you had invested your money in the five top-ranked Canadian equity funds (based on 10-year returns) back in 1996, you would have earned a paltry 4.2% annual return between now and then.

It is a pretty safe bet that you would never have considered investing in the five worst-ranked funds back in 1996. After all, that contradicts everything that most of us have been taught about going with winners. But guess what? Had you followed through on that seemingly foolish idea, you would have earned nearly 11% each year, or more than double what you would have made by going with the top-ranked performers.

**Canadian Equity Funds: 5-Year Returns as at**
	June 30, 1994	June 30, 1999
Top 20%	8.02%	10.11%
Next 20%	4.40%	11.65%
Next 20%	3.21%	12.11%
Next 20%	2.28%	12.81%
Bottom20%	1.04%	12.61%

This is no fluke. More often than not, the results have been similar for different performance measures, over varying periods. The table shown above looks at the ten years between 1989 and 1999. Note how the top performing funds during the first five years became, on average, the worst performers in the subsequent five years.

The table shown here is entirely consistent with other findings into how mutual funds tend to perform over time. These studies indicate that high-flying funds tend to drift down to earth, while lagging funds usually pick up their performance. The experts call this pattern “reversion to the mean.”

Why yesterday’s winners often become today’s losers is a complex issue. One theory goes like this: in “efficient ” stock markets like those in the US, Canada and most other developed nations, skilled fund managers are constantly competing against each other and searching for any available scrap of information that might give them an advantage. When these fund managers do learn something, they instantly buy or sell. As a result, share prices reflect all the pertinent information available. No particular investor or portfolio manager has an information advantage over the rest of the market that would enable her or him to consistently outperform the market.

Whether you agree with this theory or not, the objective evidence is clear: historical performance is rarely an indicator of future success. Your first conclusion as a mutual fund investor? You should always take performance ratings with a grain of salt.

All pages updated with mutual fund data as of: December 31, 2011