by James Parkyn
It’s been quite a rollercoaster ride for investors this year. A deep plunge in the stock market last spring was followed by a powerful rally that has sent the S&P 500 to new highs and the S&P/TSX Composite close to its high.
Let’s imagine a retirement saver, named Robert, who has been sitting on the sidelines through all this turbulence and has finally decided to take the plunge and invest a chunk of his money in the stock market.
Robert watches business news channels on TV and has heard various mutual fund managers predict where the markets and individual stocks will be heading in the coming months. With all the conflicting advice and predictions he’s heard, it’s no surprise he has a hard time deciding which managers to trust with his money.
It’s at this point that Robert and his investment advisor decide to look at the past performance of various mutual funds as a guide to finding the best ones to buy.
Of course, they know about the fine print at the bottom of mutual fund marketing materials that warns “past performance is not an indicator of future results,” but how else is Robert supposed to choose?
Sadly for him and countless other investors in actively managed funds, the fine print isn’t just perfunctory boiler plate. Past fund performance actually offers little insight into future returns.
Research by Dimensional Fund Advisors shows that just 21% of top quartile equity funds in the U.S. maintained a top-quartile ranking in the following five years (in data from 2009-2019). For fixed income, the number is 29%.
Even if you were one of the lucky ones who had invested in one of those top-performing funds, you would have had no way of knowing it when you made your investment. The odds were definitely against that outcome.
Indeed, a huge percentage of fund managers don’t generate returns over their benchmark index. In the case of actively managed U.S. equity funds, 89% underperformed the S&P Composite 1500 index over ten years to the end of 2019, according to the S&P Dow Jones SPIVA report.
Even a mutual fund manager who is able to beat the market for 10 years or longer might just be the beneficiary of random luck.
The most famous example of a manager whose luck ran out spectacularly is Bill Miller. Managing Legg Mason’s flagship fund, Miller beat the S&P 500 index for an astonishing 15 consecutive years from 1991 through 2005. Then, as the financial crisis and recession began to unfold, Miller made disastrous bets on financial stocks that led to his fund losing two-thirds of its value by the end of 2008.
Miller himself attributed his winning streak to “maybe 95% luck.” And a former investment strategist at Legg Mason estimated the probability of beating the market in the 15 years ending 2005 was 1 in 2.3 million.
The reality is that relying on past performance to choose investments is like driving your car looking in the rear view mirror. It doesn’t work (unless you’re driving in reverse). The evidence clearly shows that actively managed funds cannot consistently beat the market and studying their past performance will only gives you the illusion they can.
For Robert, the answer is to stop worrying about finding the best active managers and, instead, use passively managed index funds to build a broadly diversified, low-cost portfolio. That’s the way to keep your eyes on the road ahead and be prepared for any turns, bumps or detours that may come along the way.