Does looking at a mutual fund's track record over the last five years help to predict its future performance? Research by Dimensional Fund Advisors shows this approach offers little insight.
Dimensional looked at mutual fund performance over rolling periods from 2010 through 2020. Each year, funds were sorted within their category based on their previous five-year total return. Let's call the top performers—those ranked in the top 25%—the "rear-view-mirror funds."
Did the "rear-view-mirror" funds continue with strong performance over the following five years? Nope. As the chart below shows, few continued their hot streak.
Percentage of Top-Ranked Funds That Stayed on Top
Source: Dimensional Fund Advisors. See notes below.
A lack of persistence in strong performance casts doubt on the ability of managers to consistently gain an informational advantage. Some fund managers might be better than others, but track records alone may not provide enough insight to identify management skill. Stock and bond returns contain a lot of noise, and impressive prior performance may result from good luck. The assumption that strong past performance will continue often proves faulty, leaving many investors disappointed.
A better approach than the futility of trying to predict future winners? Utilize low-cost funds that closely track the market's performance. That's our strategy, which we call Value Added Indexing®. We use these types of funds to construct portfolios based on clients' unique circumstances, taking into account time horizon, need for liquidity, and risk tolerance.
David Rappaport, CFP®