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Think Past Fund Winners Repeat? Better Read This

I was talking to a friend of mine last week, who told me about a new fund he had added to his portfolio. "Before you get started," he added, knowing me well, "I know that past performance doesn't mean much, but I really think that this fund will be a very good one for me."

I hope he's right. But the odds are that he's wrong. Let me show you why that is.

My friend is hardly unique. Despite the standard boilerplate disclaimer that accompanies all depictions of mutual fund performance -- which informs us that past performance is no guarantee of future results -- most fund investors weigh past performance quite heavily when choosing a fund to invest in. Over the past year, for instance, funds that have earned Morningstar's highest rating of five stars have taken in 94 percent of all new money that has flowed into equity funds.

Using past performance as a main criteria seems to be a logical way to identify tomorrow's winners. If a particular fund manager was able to win the performance derby in the past, why wouldn't we want to bet that he'll win in the future?

The problem with such a belief is that it takes a very long time to distinguish between a manager who was lucky and one who is truly skillful.

For instance, let's say we gather 1,000 fund managers in a room, and ask each of them to flip a coin. If they flip heads, they remain standing and flip again; flip tails, they sit down.

After five flips, just 31 managers will be standing. And after ten flips, only one will. Should we crown this manager king of all coin flippers, believing that he's somehow divined a method of coin-flipping that will produce heads consistently? Of course not. He was simply lucky.

So it is, oftentimes, with steaks of outperformance in the mutual fund world.

To illustrate this point, I took a look at the top performing funds over periods of 10, 15, and 20 years, and calculated how they fared over the following 10, 15, and 20 years. I first took a look at the funds in each period's top quartile -- who outperformed 75 percent of their peers -- and then tracked their performance in the second period. Pure chance would dictate that 25 percent of those past winners would appear in the top quartile in the second period. But if those managers were truly skillful, we would expect to see much more than 25 percent of them repeating their strong relative performance.

So how'd they do? As you can see in the first table below, not so hot. Of the funds that were top-quartile performers in the ten years ended August 2000, only four percent appeared in the top quartile in the ten years ended August 2010. 21 percent of the 15-year top performers repeated their strong relative performance, while only 15 percent of the 20-year winners did. All of those figures, of course, are far below what we would expect from pure chance. Even more disconcertingly, more than half of those past winners ended the second period in the bottom two quartiles.

Initial Period Follow-up Period % of Funds in Top Quartile in Each Period
1990 - 2000 2000 - 2010 3.6%
1980 - 1995 1995 - 2010 20.5%
1970 - 1990 1990 - 2010 14.8%
The past winners, then, were far more likely to become tomorrow's relative losers than to repeat their success.

So let's say that instead of focusing on the top quartile, you decided to zoom in and focus your search on each period's top 10 funds -- the cream of the crop.

Bad idea. As you can see in the second table, the 10 best performing funds over the decade ended August 2000 earned an average rank of 1,338th out of 1,497 funds in the second decade. The 15-year winners ranked, on average, 414th out of 814 funds; and the 20-year winners ranked 296th out of 444 funds.

Average Follow-up Rank of
Each Period's Top Ten Funds
Period Average Rank
10 Years 1,338 out of 1,497 funds
15 Years 414 out of 814 funds
20 Years 296 out of 444 funds
As with the top quartile winners, each period's top ten funds earned returns in the subsequent period that trailed the performance of their average peer. So not only did the past winners fail to repeat their past success, they ended up being the second period's losers.

The moral of this story? Betting on past mutual fund winners to repeat their success is a losing proposition. No matter how long and impressive the track record, the odds are overwhelming that today's golden goose will be tomorrow's ugly duckling.

Might investors like my friend buck the odds and find a long-term winner? Perhaps. But successful investing is all about putting the odds in your favor, which in this case means foregoing the lure of unearthing a superstar coin flipper in favor of accepting whatever returns the market provides over the coming years via an investment in a broadly diversified total stock market index fund.

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