Luck or Skill? Why Active Funds’ Outperformance Doesn’t Last.

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A S&P Global report published this month looked at active funds’ success over time.

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Strong performance of actively managed funds can be the result of managers’ excellent skills—or pure luck. One way to tell is to look at how consistent the success is: Genuine skills tend to persist, while luck doesn’t. Many active funds, it seems, rely on luck more than skills.

“Regardless of asset class or style focus, active management outperformance is typically short-lived, with few fund managers consistently outperforming their cohorts,” Berlinda Liu, S&P Global’s director of global research & design, wrote in a report released earlier this month. S&P Global issues the same report every year in an effort to measure the persistence of active funds’ success.

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According to the report, only 35% of the domestic equity funds that ranked in the top half among peers for their performance from June 2015 to June 2016 were able to replicate that accomplishment in the following year, and just 16% did so annually through June 2020.

That’s not an anomaly: S&P Global’s reports from previous years all had similar—if not worse—results. For example, only 32% of the top-half funds from September 2012 to September 2013 did it again in the next year, and less than 4% managed to stay in the cohort annually through September 2017.

Statistically speaking, the odds that a random fund could remain in the top half for four consecutive years is 6.25%—meaning an outperforming fund sometimes has a smaller chance of achieving future success than a random one.“It’s tempting for investors to indulge in a fund with big outperformance on a one- or two-year basis, but that’s too small of a time to have any predictive value,” said Ken Laudan, portfolio manager at Kornitzer Capital Management.

However, one might argue that’s too high a bar for active managers to meet. By this standard, if a fund ranked in the top half in four out of five years but missed one year, it wouldn’t be considered a success.

“It’s unrealistic to expect any fund to outperform 10 years in a row,” Laudan said. “When it comes to consistency in risk-adjusted outperformance, it doesn’t mean you are going to outperform every year. Over a period of five or 10 years, if you can get 200 basis points [or 2 percentage points] of outperformance a year on average, I think you’ve got somebody that’s figured out a way to do it well.”

For example, the $18 billion Morgan Stanley Institutional Growth Portfolio (ticker: MSEQX) delivered an average of 34% annual gains over the past five years, more than double the S&P 500’s annual returns. But closer inspection would reveal a big discrepancy in the fund’s performance year by year.

In 2017 and 2018, the fund was one of the top among peers with 43.8% and 7.7% returns, respectively. The S&P 500 gained 21.7% in 2017 and lost 4.6% in 2018. In 2019, however, the fund fell near the bottom of the basket. It still gained 23.2% that year––not a bad return, but not enough to stand out when the S&P 500 surged 31.3% over that time period.Still, from 2015 to 2020,the Morgan Stanley fund has been one of the top performers among all large-cap active funds and its investors have received much better returns than the S&P 500 holders.

But even longer-period outperformance like this doesn’t seem to have better predictive value, according to the S&P report. Among the funds that ranked in the top half during the five-year period from June 2010 to June 2015, only 39% were able to keep their position in the next five years. Numbers from previous years’ reports vary, but the percentage was never more than 50%, or the flip of a coin.

“Choosing a fund by looking at its backward performance is somewhat a misguided strategy, in my opinion,” Gaurav Sinha, S&P Global’s Americas head of research and development, said in an interview with Barron’s. “Yes, if you look at it on a year-over-year basis, the benchmark is very high. But even if you look at the longer period, the numbers are still not too much in favor of the active managers.”

In active funds’ defense, there are a few things worth noting. Some funds are merged or liquidated each year, often due to underperformance. This arguably makes it harder for remaining funds to hold onto their positions because they’re competing in a smaller, but likely better-performing, pool of rivals.

Sometimes active funds’ inconsistent performance has more to do with the stock market’s shifting momentum rather than individual managers’ skills, too. For instance, value stocks had lagged growth peers in 2015, but outperformed in 2016. That means most outperforming growth funds in 2015, as a group, fell to the bottom in 2016, while the underperforming value funds rose to the top. Momentum shifts like this have made it very difficult for both groups to stay at the top every year, even though some managers might be able to consistently beat their peers in the respective style group through solid stock-picking skills.

Previously outperforming funds don’t always produce the same good results in subsequent years, but following the track record might be investors’ best shot after all. Previously underperforming funds have even less chance of success. Out of the bottom-half funds from 2010 to 2015, for example, only 19% made it to the top half during the next five years. Over a quarter of the group were merged or liquidated in the following years.

While few active funds could beat the market and peers consistently, sometimes the large gains in one good year could offset the losses in multiple bad years due to the more concentrated and volatile nature of active strategies. Take the Morgan Stanley Institutional Growth Portfolio: With just 37 holdings, the fund surged 128% year to date in 2020, leaving most of its peers and the S&P 500 in the dust. That alone could make up for its underperformance in 2019 and 2016.

That is precisely the point of the S&P’s persistence report: Active funds’ returns can be good for some time, but investors shouldn’t expect that to sustain. Instead, diversified index funds offer the most consistent—but likely mediocre—performance. Among all the large-cap mutual funds in the U.S., the Vanguard Total Stock Market Index Fund (VTSMX)—with over 3,500 holdings across all sectors and market caps—has been floating between the top one third and top half percentile every year since 2016.

Not too good, not too bad, just enough.

Write to Evie Liu at evie.liu@barrons.com