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Luck or Skill: Evidence from the Standard & Poor's Persistence Scorecard

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A few months ago, we wrote about the most recent version of SPIVA® (Standard & Poor’s Indices versus Active Funds Scorecard) which documents consistent subpar performance for active management. Among these types of reports, SPIVA® is unique in its use of survivorship-bias free data from the Center for Research in Security Prices (CRSP). Today, we will focus on its sister publication, The Persistence Scorecard, which has now been updated for performance through 3/31/2013.

The Persistence Scorecard answers a very simple 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? If the active managers are skillful at consistently identifying and exploiting inefficiencies in the financial markets, then they should remain in the top half without any difficulty. If, however, they are operating in a highly efficient market where outperformance is attributable to luck, then we would expect 50% to remain in the top half in the first subsequent year, 25% to remain in the top half for both of the next two years, and so on. As the bar chart below shows, the results observed by Standard & Poor’s were worse than this.



Of course, similar results are obtained when analyzing the top quartile rather than the top half, but the numbers become too small to meaningfully show in a bar chart. Of the 558 funds that began in the top quartile, only one remained there for all of the next four years. One important caveat is that funds at the bottom of their peer group due to high expenses tend to stay there. As Morningstar’s Director of Mutual Fund Research Russel Kinnel1 observed, “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. Expense ratios are strong predictors of performance.” We could not agree more. When we evaluate funds for the purpose of deciding whether we advise them to our clients, we give a high weighting to both the expense ratio and the fund characteristics associated with higher internal expenses, such as turnover. As we noted in this article, the average aggregate trading cost amongst all 1,758 U.S. domestic equity funds analyzed was 1.44%, which is added to the 1.19% average expense ratio.2  Thus, to overcome these expenses and still beat his benchmark, an active manager would have to be quite skilled or quite lucky. The Persistence Scorecard allows us to rule out the former.

If you would like to learn more about the considerations that go into choosing high quality index funds, as well as which ones are irrelevant, please drop us a line at [email protected] or call us at 888-643-3133.

1How Expense Ratios and Star Ratings Predict Success,” August 9, 2010. Data Period (March 2005 – March 2010).

2Edelen, Roger, Richard Evans & Gregory Kadlec. "Shedding Light on ‘Invisible' Costs: Trading Costs and Mutual Fund Performance." Financial Analysts Journal: Vol. 69, No. 1, 2013