Persistence Scorecard Doesn’t Predict Investor Success

October 17, 2019

It has become a ritual.

S&P Dow Jones Indices publishes its Persistence Scorecard, as it does periodically. The Scorecard shows that – yet again – actively managed funds haven’t been able to achieve a year-after-year outperformance in certain time periods. Its publication prompts a series of news reports, op eds and social media commentary that – yet again – bemoan the shortcomings of active management.

But, as with any ritual, the persistence discussion has taken on a life of its own. It’s time to stop and ask a fundamental question: does the Persistence Scorecard add value for investors?

-The Persistence Scorecard uses a definition of persistence that doesn’t align with the average investor’s priorities, which are usually focused on long-term goals, such as funding a child’s education or saving for retirement. Specifically, S&P calculates the percentage of funds in a category that outperform in every year in a three-year period (a “three-peat”) or every year in a five-year period (a “five-peat”).

Unfortunately, there are two problems with the Scorecard’s approach:

1. Actively managed funds don’t need year-after-year outperformance to generate long-term value for investors.
2. The discussion about short-term persistence misses the broader point – which is that investors are most concerned about predictability of long-term performance.

Let’s take a closer look at both of these points.

Long-Term Performance Matters, Not Short-Term Persistence

Unfortunately, “three-peats” and “five-peats” don’t mean much for investors.

The numbers tell the story: The funds with the best returns over the long term almost all experience shorter periods of underperformance.

To illustrate, we looked at the performance of the 220+ separate share classes of actively managed large-cap blend funds with 20-year track records as of the end of December 2018. We then zeroed in on the 50 funds with the best performance history.

These 50 funds have done an amazing job for shareholders over the past decades. On average, they have paid back investors more than 4 times over, returning 7.7% per year. By contrast, investors in the S&P 500 would have earned only 5.6% per year, not quite tripling their money.

However, while these funds generated spectacular results over the long haul, results varied quite a bit over the short term. Looking at quarterly performance, these top 50 funds were in the top quartile 36% of the time — and in the bottom quartile 28% of the time.

What’s most interesting is that these 50 best funds were in the bottom quartile almost as often as the 50 weakest funds – 28% for the top funds versus 30% for the bottom funds. However, the top 50 funds were more likely to place in the top quartile (36% of the time) versus just 22% for the bottom funds.

Even top-ranked funds have periods at the bottom (Data source: Morningstar)

Put another way, these winning funds would have failed the S&P’s persistence test in at least some periods, because they didn’t outperform in every year. But as this example shows, persistence isn’t required to achieve success for investors over the long haul.

Predictability of Long Term Performance Matters More than Short-Term Persistence

But how did persistence even become a litmus test for mutual funds in the first place? “Persistence” is a term that is often used in the academic literature on mutual fund performance to address the concept of luck versus skill. If a manager is skilled, outperformance in the past will likely “persist” in the future. If a manager is merely lucky, however, past outperformance is much less likely to repeat or persist in the future.

A segment of the literature studies patterns in mutual fund returns to determine if fund managers are, overall, more skilled or more lucky. The Persistence Scorecard is a variant on these types of studies.

However, the question of whether fund managers in general are skilled (or not) is of lesser interest to investors. What is most helpful to investors is being able to predict which managers will help them reach their goals. Fortunately, the weight of the academic literature suggests that finding skilled managers isn’t just a matter of luck.

In a recent paper, Professors K.J. Martijn Cremers, Jon A. Fulkerson and Timothy B. Riley review the active manager characteristics and behavior that are solid indicators of future performance. Investment approach is particularly important. Notably, managers with a highly active approach – as determined by “active share” or other similar measures — are more likely to add value for their investors. Low turnover strategies, effective trading and a willingness to hold unpopular stocks are also associated with superior results. Other viable predictors of outperformance are portfolio manager education and work experience, manager ownership of the fund and, yes, even past performance. (For a more thorough discussion on this literature, see “Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of the Academic Literature on Actively Managed Mutual Funds” (forthcoming, Financial Analysts Journal.)

Conclusion

In short, it’s time to end the ritual. Investors and media should give the Persistence Scorecard the short shrift that it deserves.