(Excerpts from a Suzan Abboud column written for MoneySense in 2001. The column illustrates a still very popular investment concept known as "Reversion to the Mean").
If you've ever
researched which mutual funds to buy, youve probably had one thought drummed into
your head: always buy top-performing funds. If youve read any of the popular mutual
fund analysts, youve probably seen endless variations on this statement: Fund
XYZ is doing the right things. However, we would not recommend it until we see some
improvement in performance.
No wonder so many of us
wind up disappointed with our fund selections. If we followed these experts advice,
we wouldn't buy a fund until it had already started to outperformin other
words, when it is already too late, thank you. The fact is that if you had invested your
money in the five top-ranked Canadian equity funds (based on 10-year returns) back in
1996, you would have earned a paltry 4.2% annual return between now and then.
It is a pretty safe bet that
you would never have considered investing in the five worst-ranked funds back in 1996.
After all, that contradicts everything that most of us have been taught about going with
winners. But guess what? Had you followed through on that seemingly foolish idea, you
would have earned nearly 11% each year, or more than double what you would have made by
going with the top-ranked performers.
Canadian Equity Funds: 5-Year Returns as at
||June 30, 1994
||June 30, 1999
This is no fluke. More often than not, the results
have been similar for different performance measures, over varying periods. The table
shown above looks at the ten years between 1989 and 1999. Note how the top performing
funds during the first five years became, on average, the worst performers in the
subsequent five years.
The table shown here is entirely consistent
with other findings into how mutual funds tend to perform over time. These studies
indicate that high-flying funds tend to drift down to earth, while lagging funds usually
pick up their performance. The experts call this pattern reversion to the mean.
Why yesterday's winners often become today's
losers is a complex issue. One theory goes like this: in "efficient" stock
markets like those in the US, Canada and most other developed nations, skilled fund
managers are constantly competing against each other and searching for any available scrap
of information that might give them an advantage. When these fund managers do learn
something, they instantly buy or sell. As a result, share prices reflect all the pertinent
information available. No particular investor or portfolio manager has an information
advantage over the rest of the market that would enable her or him to consistently
outperform the market.
Whether you agree with this theory or not, the
objective evidence is clear: historical performance is rarely an indicator of future
success. Your first conclusion as a mutual fund investor? You should always take
performance ratings with a grain of salt.