Don't Look in the Rear View Mirror When Investing

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 2012 through 2022. 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. 

The exhibit below shows that among equity funds ranked in the top quartile based on previous five-year returns, a minority also ranked in the top quartile of returns in the following five-year period.

Percentage of Top Ranked Funds That Stayed on Top

Source: Dimensional Fund Advisors. See notes below.

A lack of persistence casts further doubt on the ability of managers to consistently gain an informational advantage on the market. 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 track records 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.

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The author does not intend to provide investment, legal or tax advice as these materials are for general educational purposes only. Please consult your legal, tax or investment professional for advice on your particular situation. This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. It is not intended to be a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction. Investing involves risk including the possible loss of principal. Past performance does not guarantee future results. Please refer to RRCM’s Form ADV Part 2 for additional disclosures regarding RRCM and its practices.

Dimensional Notes

This study evaluated fund performance over rolling periods from 2012 through 2022. Each year, funds are sorted within their category based on their previous five-year total return. Those ranked in the top quartile of returns are evaluated over the following five-year period. The chart shows the average percentage of top-ranked equity and fixed income funds that kept their top ranking in the subsequent period. Data Sample: The sample includes US-domiciled, USD-denominated open-end and exchange-traded funds (ETFs) in the following Morningstar categories. Non-Dimensional fund data provided by Morningstar. Dimensional fund data is provided by the fund accountant. Dimensional funds or subadvised funds whose access is or previously was limited to certain investors are excluded. Index funds, load-waived funds, and funds of funds are excluded from the industry sample. Morningstar Categories (Equity): Equity fund sample includes the following Morningstar historical categories: Diversified Emerging Markets, Europe Stock, Foreign Large Blend, Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Blend, Foreign Small/Mid Growth, Foreign Small/Mid Value, Global Real Estate, Japan Stock, Large Blend, Large Growth, Large Value, Mid-Cap Blend, Mid-Cap Growth, Mid-Cap Value, Miscellaneous Region, Pacific/Asia ex-Japan Stock, Real Estate, Small Blend, Small Growth, Small Value, Global Large-Stock Blend, Global Large-Stock Growth, Global Large-Stock Value, and Global Small/Mid Stock. Morningstar Categories (Fixed Income): Fixed income fund sample includes the following Morningstar historical categories: Corporate Bond, High Yield Bond, Inflation-Protected Bond, Intermediate Core Bond, Intermediate Core-Plus Bond, Long-Term Bond, Intermediate Government, Long Government, Muni California Intermediate, Muni California Long, Muni Massachusetts, Muni Minnesota, Muni National Intermediate, Muni National Long, Muni National Short, Muni New Jersey, Muni New York Intermediate, Muni New York Long, Muni Ohio, Muni Pennsylvania, Muni Single State Intermediate, Muni Single State Long, Muni Single State Short, Muni Target Maturity, Short Government, Short-Term Bond, Ultrashort Bond, Global Bond, and Global Bond-USD Hedged. Index Data Sources: Index data provided by Bloomberg, MSCI, Russell, FTSE Fixed Income LLC, and S&P Dow Jones Indices LLC. Bloomberg data provided by Bloomberg. MSCI data © MSCI 2023, all rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. FTSE fixed income indices © 2023 FTSE Fixed Income LLC. All rights reserved. S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment. Their performance does not reflect the expenses associated with management of an actual portfolio. US-domiciled mutual funds and US-domiciled ETFs are not generally available for distribution outside the US. There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results.