Does Rear-View-Mirror Investing Work?

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. 

Dimensional Notes:

This study evaluated fund performance over rolling periods from 2001 through 2020. 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. US-domiciled, non-Dimensional open-end mutual fund data provided by Morningstar. 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, World Large Stock, and World Small/Mid Stock. 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, 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, Target Maturity, Ultrashort Bond, World Bond, and World Bond-USD Hedged. See Dimensional’s Mutual Fund Landscape 2021 for more detail. Index data provided by Bloomberg Barclays, MSCI, Russell, FTSE Fixed Income LLC, and S&P Dow Jones Indices LLC. Bloomberg Barclays data provided by Bloomberg. MSCI data © MSCI 2021, 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 © 2021 FTSE Fixed Income LLC. All rights reserved. S&P data © 2021 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. There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results.

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.