Every year Dimensional analyzes returns of U.S. based mutual funds to determine how many funds outperform their benchmarks after costs. Many funds do not survive. And only a small percentage both survive and outperform benchmarks.

Their analysis also answered the question, “Do top ranked funds repeat?”, meaning are the funds who performed well in the past the same funds that perform well in the future?

Their analysis found that top funds do not repeat. Funds with 5-year returns in the top 25% of funds, on average, do not repeat their top ranking. What’s more, the number that did repeat was about same as what you would expect from chance alone.

They conclude: The research suggests that a fund’s past performance is not enough to predict future returns.

We would make the statement about past performance even stronger. Not only is a fund’s past performance not enough to predict future returns, its past performance has little if anything to do with future returns.

Many investors wrongly use past performance as a primary criteria to select mutual funds. Even a decade of superior performance has very little to do with the next decade of performance. It is also a mistake to think that the higher fees of an actively managed fund are worth it. Low cost is probably the best predictor of future superior returns.

One of the reasons why index investing often beats active managed funds is because the mean return of an index is higher than the median return of its components. The middle stock of 500 stocks has a lower return than the average of 500 stocks. The handful of lottery winning stocks pull up the average while the stocks in the middle of the pack have a lower average. Stock pickers, on average, miss the lottery winning stocks, so they underperform the average. Meanwhile the few funds that happen to hit a lottery winning stock have superior returns. They wrongly think they are brilliant. But over the next five years, like every other stock picker, they on average miss the lottery winning stocks and fail to repeat their good fortune.

Meanwhile an investor with low cost index funds consistently receives the market average return of all stocks including a small share of the lottery winning stocks. This consistent return beats the hit and miss approach of actively managed funds.

At the end of the video the narrator says, “At Dimensional, we believe investment strategies can be designed and managed in a way that can outperform the markets without having to outguess it.”

The statement is based on the idea that there are investment factors such as value, size, quality, and more which can result in a higher mean return. Over weighting stocks with these factors as you craft the sectors of your asset allocation can produce a higher mean return and beat conventional benchmarks.

We believe that portfolio construction based on factors is better than blindly picking whatever funds have the best past performance.

Here is the full video and analysis of Dimensional:

 

Photo by Marvin Ronsdorf on Unsplash