Lack of investment persistence = underperformance

 David Peartree, The Daily Record Newswire

It is no longer controversial to assert that most active stock managers underperform their relevant market benchmark. This is now an indisputable fact, bolstered by numerous academic studies as well as the annual S&P Persistence Scorecard published by S&P Dow Jones Indices.

Still, facts can look different depending on one’s perspective. Proponents of index investing rightly point out that in most years a majority of active stock managers underperform. For example, in 2013, 55 percent of U.S. large-cap managers and 68 percent of U.S. small-cap managers underperformed their respective benchmarks, while U.S. mid-cap managers did better — only 39 percent underperformed.

Proponents of active management view those figures differently, however, and point out that the number of active managers who outperform is far from piddling. Again looking at 2013, 45 percent of U.S. large-cap managers, 32 percent of U.S. small-cap managers, and an impressive 61 percent of U.S. mid-cap managers were able to outperform their market benchmark.

Past one year, the number of active stock managers who outperform declines significantly, but even then the number of managers who outperform their market benchmark is not insignificant. For example, over the three and five-year periods ending 2013 the percentage of all U.S. stock funds that underperformed their benchmark was 77 percent and 60 percent respectively. That means 23 percent and 40 percent of managers outperformed over three and five years.

Proponents of active management look at those figures and conclude that roughly one third of active stock managers are able to outperform their market benchmark over three and five-year periods. Never mind for the moment that these performance figures deteriorate even further over longer periods. One out of three appears to be reasonably good odds, so why shouldn’t an investor take a chance on picking a superior manager?

The answer is a lack of investment persistency. Most winners don’t stay winners. Whether one looks at the top quartile or the top half of performers, the fall from grace is swift and hard.

For example, the 2013 S&P Persistence Scorecard found that of 692 U.S. domestic stock funds in the top quartile as of September 2011, only 7 percent managed to stay in the top quartile by the end of September 2013, only two years later. Even worse was the performance of top quartile funds over a five-year period. Out of 710 funds in the top quartile as of September 2009, only 2 percent remained in the top quartile by September 2013. Those results were consistent across all sub-categories of U.S. stock funds.

What happened to all those top quartile performers? Most of them dropped to the bottom half. Very few were able to stay in the top half over three- and five-year periods.

Out of 1385 U.S. domestic stock funds in the top half as of September 2011, only 22 percent remained in the top half by September 2013. The performance over five years was even worse. Out of 1421 U.S. domestic stock funds in the top half as of September 2009, only 7 percent remained in the top half by September 2013. Again, those results were consistent across all sub-categories of U.S. stock funds.

The low persistency of top-performing stock funds is consistent with random expectations. The managing director of S&P Indices observed that, “every single report we have published (since 2005) shows that the chances of finding a top-quartile fund for the future by using historical top-quartile performance is similar or less than random expectations.”

Interestingly, although we are constantly reminded that “past performance is not indicative of future performance,” it turns out that in one case past performance is indicative. Bottom tier funds have a much higher risk of being shut down, generally due to poor performance.

Over three- and five-year periods, never mind longer periods, top quartile funds fall, most of them into the bottom two quartiles. Funds in the bottom quartile, and even the bottom half, consistently close — either through merger with another fund or liquidation — at a higher rate than funds in the top quartiles.

Over three years ending 2013, over 28 percent of bottom quartile funds and over 25 percent of bottom half fund were closed. Over five years, over 36 percent of bottom quartile funds and 32 percent of bottom half funds were closed.

Over several years, the number of active stock managers who can outperform their benchmark is roughly one out of three. While that number seems to offer investors a reason to hope for the success of active management in their portfolios, the downfall is a lack of persistency. Top performance does not persist. After only three to five years, the number of fund managers remaining in the top quartile approaches insignificance.

Active stock management offers the possibility of superior performance, and there will always be some who succeed. Over time, however, the number of superior performers diminishes steadily.

Possibilities are one thing; probabilities are another. Investors seeking the highest probability of capturing the returns from the financial markets, less a small expense, may be better served with an index-tracking portfolio.

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David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.