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 biannually 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 its core, this 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 time periods?

The answer is pretty stark, according to the latest analysis by S&P's researchers. They studied returns for U.S. equity funds over 10 years (through 2020), separating such performance data into quartiles (25%) and comparing each fund's returns over subsequent yearly periods. During the initial five-year stretch (2011 through 2015), S&P's researchers found domestic equity fund managers who had outperformed at least 50% of their peers "had little luck maintaining their top-half status" in subsequent years.

Looking at managers who invested across market capitalization sizes and styles, the study's authors added, "the chances of a top-half fund changing style or liquidating" showed similar "odds of remaining in the top half."

How inconsistent was active management's outperformance? As you can see from the chart below, a vast majority of surviving fund managers weren't able to keep producing peer-beating returns in the most recent full five-year period reviewed (2016-2020). That's even after adjusting for such shenanigans as survivorship bias and style drift. (It's also worth pointing out that S&P's researchers screened using a fairly low bar — how many active funds were able to outperform their closest rivals, not their respective indexes.) 

Another sobering finding uncovered by the latest S&P Persistence Scorecard was how quickly any one-year burst in active management's performance tended to erode in subsequent years.

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 (25%) of their peers' overall results — wound up showing a significant erosion in results from the first year through subsequent years.

The chart below reinforces a view of how any spurt of 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:

"Can 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. The Persistence Scorecard measures that consistency and shows that, regardless of asset class or style focus, active management outperformance is typically short-lived, with few funds consistently outranking their peers."


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