Screen Out Inferior Mutual Fund Performance — BUT ONLY AFTER using other ETF and mutual fund selection criteria
Superior or even average mutual fund performance in the past simply DOES NOT predict similar fund performance in the future.
However, the investment research literature does provide some modest evidence that substantially inferior past mutual fund performance is more likely to lead to inferior mutual fund returns in the future. Excessive costs and high management expense ratios are the likely culprits, when explaining sub-par diversified investment fund returns.
Choosing solely from among mutual funds that have performed very well in the past can lead you to very significant mutual fund screening errors
The primary objective of using scientifically grounded mutual fund screening criteria is to identify a much smaller group of mutual funds for more careful evaluation. Of course, the whole point of screening mutual funds and ETFs is to increase your chances of investing in funds that are more likely to perform better in the future on both a sustained, long-term basis and on an risk-adjusted investment basis.
As a first step in their mutual fund screening process, far too many individual investors and their financial advisors instinctively start by sorting funds on the basis their superior historical performance. They want to choose only from among those mutual funds that have performed the best in the past. They hope that superior past performance will continue into the future.
Both this instinct and this mutual fund screening approach can be fatally flawed. Choosing only from among past higher performing diversified investment funds can lead to major mutual fund selection mistakes. These mistakes arrive in many forms, including inferior gross mutual performance, higher management expense ratios, expensive sales loads and marketing fees, and/or higher trading costs due to higher fund turnover.
How smart, but naive, individual investors may choose lousy mutual funds on the basis of superior past mutual fund performance
For example, if you choose a high cost and high turnover five-star fund with a superior, but largely lucky, past mutual fund performance record, then you can set yourself up for some real future investment performance troubles. If this mutual fund performance record does not continue into the future, then you will still end up paying a high management expense ratio and high, hidden fund turnover trading costs.
You will just to get mediocre future performance on a “gross” returns basis. When higher annual management expense ratio costs, higher hidden trading or turnover costs, and higher short term capital gains taxes are taken into consideration, then the result will be inferior performance on a “net” returns basis. What appeared to be a big winner, when it was owned by someone else, becomes a big loser, when you own this fund.
An additional reason why you might have decided to buy this high cost mutual fund could have been, because you were only sold “superior” mutual funds. Perhaps a financial advisor selectively offered to you only those mutual funds with higher past performance and 4-star and 5-star mutual fund ratings. Because you were naively inclined to buy on the basis of past performance, it was much easier for the investment counselor or financial adviser to make the sale to you by suggesting only four star and five star funds.
In the process of purchasing this fund, you may also have paid a substantial front end sales load or back end sales load. If you paid a sales load, then an annual 12b1 marketing fee probably was also tacked on to the annual management expense ratio to pay your financial advisor to “serve” you.
Now, your investment picture gets even worse. Instead of putting 100% of your dollar to work in the investment fund, perhaps only 95 cents will actually make it into the fund to work for you. In addition, the 12b1 fee drives up your annual costs even higher.
You bought this fund, because you earnestly thought you were buying a “better” mutual fund or ETF. It seemed like a good investment, because the past mutual fund performance had been better. Furthermore, your financial advisor or investment counselor, actually said that the fund was “better” fund or at least implied that this was a better fund by pointing out its performance chart or its then 5 star rating, which has since faded and lost its sparkle.
Securities sales brokers, investment counselors, and financial advisors get paid more, when you pay them more. That is why they shamelessly tell you or imply that you must buy more expensive diversified investment funds and “pay more to get better performance.” This is unmitigated rubbish.
Investment research studies indicate that superior past mutual fund performance simply does not indicate that there will be superior future performance — particularly after higher costs and taxes are considered.
When historical mutual fund performance is evaluated carefully in well-designed statistical studies, there is very little evidence that managers of funds with superior past performance will sustain this performance into the future. (ETFs are too new to have a similar body of historical research, but the substantial similarities between mutual funds and ETFs make contrary findings unlikely.)
Past fund success is simply not an indicator of future success.1 In fact, superior past fund performance seems not to indicate any more than the likelihood that a fund is likely to have average performance in the future. Funds that recently demonstrated average performance in the past are equally likely to have average or superior performance into the future, as well.
Therefore, previous superior or average past mutual fund performance does not predict similar future performance. Some average and some superior performing funds in the past will be average in the future and some will do better or worse than the average.
An average or superior past performance chart tells you absolutely nothing to aid you in your mutual fund selection process. However, there is modest evidence that substantially inferior past fund performance is more likely to lead to continued inferior performance in the future. Significant past failure is a mild indicator of future failure.
Given that big past losers have a mild tendency to keep losing, but past winners are likely to be average in the future, these findings should change significantly how one should use historical performance indicators. Instead of starting by selecting only the best past performers, The Pasadena Financial Planner believes that investors are far better served by first applying other much more useful mutual fund selection criteria.
Before evaluating past mutual fund performance, use the first 6 of these 7 objective mutual fund and ETF screening criteria.
These 7 screening criteria can help you to screen the tens of thousands of available diversified investment funds to get down to a more manageable list of diversified investment funds to evaluate. The first 6 mutual fund screening criteria below will yield a much shorter diversified investment fund list.
Only then, should an investor use historical performance measures to evaluate the screened list and only then with the sole objective of eliminating those funds that have had a history of sustained and significant under performance. The investor can then use the web and other sources to research in greater depth the remaining funds on the screened list – whether or not their prior performance has been average or superior. Just eliminate any funds with substantially inferior past performance from this smaller diversified investment fund list.
Note that in reality however, after you have knocked out funds with 1) sales loads and 12b1 fees, 2) high management expense ratios, 3) high turnover and trading costs, 4) large actively managed funds, 5) immature funds, and 6) small inefficient funds, you are relatively unlikely to have any funds remaining that have substantially inferior past performance. Since these other six mutual fund screening criteria are inversely correlated with lousy mutual fund performance, you are very likely to have already eliminated the past performance dogs. as well.
1) The Best Mutual Funds Have NO Sales Loads and NO 12b-1 Fees
The great majority of investors buy funds through financial advisors, and they pay a very, very high price over their lives for doing so. This is especially true, since financial advisers tend to promote funds with higher costs that reduce mutual fund performance. Zero is the maximum amount of front-end load and back-end load fees that you should to pay. Zero is the maximum marketing or 12b-1 fee you should pay. Just say no. Buy no load mutual funds directly without using costly advisers.
2) The Best No Load Mutual Funds Have VERY LOW Management Expenses
Lower annual ETF and mutual fund management expense ratios are better. Lowest is usually best. Many no load index funds and ETFs have management expense ratios below .25%. Favor them.
3) The Best Noload Mutual Funds Have VERY LOW Portfolio Turnover
Lower portfolio turnover is better. Look for single-digit and very low double-digit annual portfolio turnover rates in the no load index funds and ETFs that you purchase.
4) Avoid Large Actively Managed Mutual Funds
When they trade their overly large portfolio positions, large actively managed funds tend to affect securities market prices negatively. This drags down their net mutual fund performance. High turnover by large funds should be a big red flag to you.
5) Choose Mature Mutual Funds
The ETF and mutual fund industry throws a whole lot of new fund spaghetti on the wall to see what will stick. You do not want to be part of this process. Pick more mature mutual funds that have been in business for at least a few years.
6) Avoid Very Small Mutual Funds
Small funds cannot operate efficiently. They need a minimum critical mass of assets to fund required management expenses. Simply avoid very small funds under one hundred million or two hundred million dollars in assets.
7) Screen Out Inferior Mutual Fund Performance
Evaluate the historical investment performance of mutual funds and ETFs, but only AFTER using other screening criteria. Superior or average past fund performance tells you ABSOLUTELY NOTHING about how a fund will perform in the future. Pay attention to the fine print in the prospectus that says that past performance does not indicate future performance, because this has been shown to be true.
Modern, highly competitive, and real-time securities markets are auction price setting mechanisms that force the mass of smart and not-so-smart professional and amateur investors to accept largely average returns over time. Only very poor past performance tends to indicate potentially sub-par performance in the future, and that is probably due to higher costs. Therefore, eliminate only the worst of historical performance during fund screening and choose from the remainder — despite whether a fund has had superior, average, or even somewhat below average performance in the past.
Net of costs, four and five star funds are no better than three star funds and probably no better than even two star funds. Eliminate the bottom one-tenth to one-third of funds on a historical performance basis and choose from the remaining nine-tenths to two-thirds without stressing their past performance. Instead, choose no load index funds with very low costs and turnover. (Also, see: Do Morningstar Ratings predict risk-adjusted equity mutual fund performance?)
1) Mark M. Carhart “On Persistence in Mutual Fund Performance.” The Journal of Finance, 1997, Vol. LII, No. 1: pp 57-82
