Why Active Funds Falter

Even if you follow all the pointers in the previous section, there’s a good chance the funds you pick will turn out to be duds. Let’s say you bought the large-cap, mid-cap, small-cap and multi-cap stock funds that ranked in the top 25% of performers over the five years through March 2012. What percentage of these top performers remained in the top 25% over the subsequent five years—the period through March 2017? If the results were purely random, you would expect the answer to be 25%.

But in fact, it was even worse than chance would suggest: Among these top performers, just 20.1% of large-cap funds, 15.4% of mid-cap funds, 14% of small-cap funds and 21.5% of multi-cap funds remained in the top quartile, according to the Persistence Scorecard from S&P Dow Jones Indices, a division of S&P Global. Why do successful funds falter? Here are seven reasons:

First, there are investment costs. If an actively managed fund charges annual expenses of 1%, that’s a 1% shortfall the fund has to make up each year, just to stay even with the market. Yes, a few lucky investors will manage to outperform. But thanks to investment costs, investors as a group must inevitably earn less than the market averages.

Second, the market is reasonably efficient, meaning stocks and bonds tend to reflect all publicly available information. With so many professional investors poring over the market each day, bargains are not easy to find.

Third, the stock market averages tend to be skewed higher each year by a small number of stocks with spectacular gains, so a majority of stocks lag behind the market averages. Most managers will own few—if any—of these spectacular performers, so they end up trailing the market.

Fourth, even if a fund has some initial success, that success will often attract a heap of dollars from new investors, making the manager’s job harder—and hurting future performance.

Fifth, different market sectors and different investment styles cycle in and out of favor. Even if a fund fares well relative to other funds with a similar style, it may be that the fund sparkled because it employed a slightly different investment approach—and that approach goes out of favor.

Sixth, a growing number of funds are quantitatively driven. If a manager figures out some combination of data points that helps identify winning stocks, there’s a good chance others will quickly catch on—and the advantage will disappear

Finally, what looks like skill might turn out to be luck. If someone flips a coins five times in a row and gets heads each time, we know it was just luck. In fact, if you have 32 people flipping coins, probability suggests one of them would flip five heads. Found a fund with a great five-year record? You may be looking at a manager who got lucky for five consecutive years.

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