Step 3: Stock Pickers updated

Luck or Skill: Evidence from S&P's Persistence Scorecard

Step 3: Stock Pickers updated

Besides tracking active fund managers against their respective benchmarks, Standard & Poor's fund researchers also compare how consistently recent top-performers are able to keep producing winning records in subsequent years. 

The U.S. Persistence Scorecard, as it's called, serves as an extension of S&P Dow Jones Indices' SPIVA (Standard & Poor Indices Versus Active) report. Both of these research series are noteworthy in that S&P scrubs results for so-called survivorship bias. Such a bias amounts to a statistical shell game played by active managers in which old funds are merged or shuttered, yet final performance results don't take such manifestations into account.

Like its SPIVA cousin, S&P's Persistence Scorecard also considers how often active fund managers shift their investment focus. This is known in the industry as "style drift," and can skew comparisons between competitors in similar categories.

At IFA, our wealth advisors warn investors against trusting studies that don't scrub numbers to account for survivorship bias and style drift. In our view, this S&P research series also stands out from the pack for its underlying approach to digging deeper into core SPIVA data.

The Persistence Scorecard tracks the percentage of U.S. equity funds that remained in the top-quartile (25%) or top-half (50%) rankings over five-consecutive annual periods (through 2021). As you can see from the charts shown below, since the first year (2017) is used as a statistical reference point for the following year, the data comparison begins in the subsequent year, in this case 2018.

In essence, the Persistence Scorecard is asking a rather straightforward question: If we have an active fund that was in the top half of its peer group over the prior year, what are the odds that it will remain there in subsequent years? 

The answer is fairly stark, according to the latest analysis by S&P's researchers. In shorter timeframes, they found that some active funds showed an ability to outperform for a year or two. This led the Persistence Scorecard's authors to ask: "Had these funds developed a consistent winning strategy?" As the timeframe compared was extended across three-straight years, their answer was rather succinct: "Sadly, no." 

Once the scorecard's horizon was broadened to five years, "the picture looks even more bleak," the researchers noted. 

How inconsistent was active management's outperformance? As you can see from the following pie charts, a vast majority of surviving fund managers weren't able to keep beating their respective benchmark returns from one year to the next in the most recent period reviewed. And that's even after adjusting for such shenanigans as survivorship bias and style drift.  

The latest S&P Persistence Scorecard provided even more sobering data revealing how quickly one-year performance bursts by active managers can start to erode. This might seem counterintuitive. After all, if fund managers were skillful at consistently picking individual stock winners, then they should remain in the top half without much difficulty. That clearly didn't turn out to be the case in the four major equity categories (All Domestic Funds, All Large-Cap Funds, All Mid-Cap Funds and All Small-Cap Funds) studied by S&P in this research report. (See bar chart below.) 

Even refining such an analysis to just the top outperformers — i.e., those managers whose funds scored in the top quartile of their peers' overall results — wound up showing steep declines from the first year through subsequent years. The chart below, which uses S&P data, provides more evidence that any short-term outperformance by active stock pickers is based primarily on luck, not skill.  

Whether measured by the top 25% or more broadly (top half), the S&P researchers noted that persistence in outperformance tends to be greater over shorter investment horizons. As they summarized:

"Should investment results be attributed to skill or luck? Genuine skill is likely to persist, while luck is random and fleeting. Thus, one measure of skill is the consistency of a fund's performance relative to its peers or to its benchmark. The Persistence Scorecard shows that regardless of asset class or style focus, active management outperformance is typically short-lived, with few funds consistently outranking their peers or benchmarks."

Also worth noting: The most recent Persistence Scorecard found that in some categories during certain short periods, "numbers are occasionally better than what would be expected if fund performance was randomly distributed." Even though a rather small number of active managers might show some signs of outperformance, say around 3%, the odds for such funds falling along the lines of a normal distribution might be even lower.

"While the persistence report does not prove that fund performance is completely random," the S&P researchers note, "from a practical or decision-making perspective, it reinforces the notion that choosing between active funds on the basis of previous outperformance is a misguided strategy. After all, there remains a 96.8% chance that a top-quartile fund will not stay in the top quartile for the next four years."


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