Stock picking and market timing are common strategies used by investors in pursuit of superior performance. Unfortunately, these activities tend to get investors into trouble. We have written about this many times in the past, including:

• Do Active Funds Beat the Market?
• The Dangers of Market Timing

There is another strategy that we have not previously covered. It involves performance chasing across actively managed mutual funds.

A common method individual investors use when selecting among investment fund options is to sort by returns and select the manager(s) with the best performance. This process is problematic for a variety of reasons. First and foremost, this technique may result in a portfolio that is not properly diversified. If proper care is not exercised when selecting among fund options, an investor may be left with a portfolio that is overly concentrated in some areas and largely omits others.

Another major challenge relates to subsequent performance after the funds are selected. As we previously wrote in ‘Do Active Funds Beat the Market,’ actively managed funds have a terrible performance record. Very few funds keep pace with their benchmark over long periods of time. As it turns out, knowing which funds have actually done well historically is of little help to investors. 

The chart below from Dimensional Fund Advisors evaluates the performance of top-performing funds. It looks at those funds that ended in the top quartile of their peer group over a five-year period and analyzes the results over the next five years. The results were not encouraging. 

As you can see from the table, the few funds that ranked in the top quartile actually remained there from one period to the next. Across the various equity categories, only 22% of the top-performing funds remain a top-performing fund in the subsequent five years. The data is slightly better for fixed income, but the funds that do demonstrate some persistence still represent a distinct minority. As a result, those who chase performance across fund managers are likely to be disappointed by the result.

Investors are much better off focusing on building a well-diversified portfolio using funds that are low-cost, have low turnover, and are tax efficient. Rather than trying to outguess the market, expected returns can be improved by tilting the portfolio toward companies that are small, low-priced, and highly profitable. Each of these characteristics has been shown to deliver higher returns over time.