Track Record

Vanguard Quantifies the Impact of Performance-Chasing

Track Record

For many years now, IFA has called attention to the dismal performance of individual investors. The chart below shows the results of the DALBAR study which details how the average individual fund investor has severely lagged the S&P 500 Index.

At the heart of this poor performance is the destructive behavior of performance chasing—buying the funds that have had recent good performance and selling the funds that have had the opposite. One study that we repeatedly cite is The Selection and Termination of Investment Management Firms by Plan Sponsors which shows that even sophisticated institutional investors fall victim to this behavioral pitfall. The chart below shows the frustrating consequences of this performance-chasing:

Vanguard Research recently published a research note that attempts to quantify the impact of performance-chasing by calculating returns of hypothetical manager-picking strategies as opposed to returns actually received by investors. Specifically, they analyzed two different strategies over the ten-year period ending 12/31/2013. The “performance-chasing” strategy started with funds that had above- median returns for the prior three-year period and when those funds’ rolling 3-year returns fell below the median, they were sold and replaced with funds that had above-median returns. The buy-and-hold strategy picked any fund at random and stayed with it, unless the fund was terminated in which case it was replaced with a fund that had a return at the median. The study covered 3,568 domestic equity funds that were divided into nine style groupings based on size and value.  The bar chart below shows that the buy-and-hold strategy trounced the performance-chasing strategy across the board.

In addition to looking at returns on an absolute basis, the authors also calculated risk-adjusted returns (Sharpe ratios) and obtained the same overall results. The authors are quick to point out that if fund performance were persistent then performance-chasing would be a viable strategy. Unfortunately, that is not the case, as we recently discussed in this article that summarizes the findings of S&P Dow Jones Indices in their Persistence Scorecard.

In closing, we wholeheartedly agree with the authors’ conclusion:

“Our research furthermore reaffirms the importance of an oft-cited but frequently ignored legal disclaimer about investing: Past performance is not necessarily indicative of future results. This statement certainly appears to hold true among recent top-performing funds, and investors are well-advised to remind themselves regularly of it.”