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By Paul Kaplan and Christian Charest | 04-10-2018

Good funds can go through very long dry spells

According to new Morningstar research, funds that beat their index over 15 years go through bouts of underperformance lasting about 9 years on average.

Christian Charest: For Morningstar I'm Christian Charest. In the investment world we're always told that past performance is no guarantee of future returns. And in light of new research the information we glean from looking at fund returns may be even less meaningful than we thought. Last month Morningstar published a paper titled "How Long Can A Good Fund Underperform Its Benchmark". Which provided some interesting takeaways in that regard.

I'm here today with Dr. Paul Kaplan, one of the co-authors of that paper.

Paul, thank you very much for being with us today.

Dr. Paul Kaplan: Thanks for having me.

Charest: So, to begin with, can you give us a general idea of what the research looked at.

Dr. Kaplan: So, what we looked at was for funds that outperformed their benchmarks over a 15-year period, how long within that 15 years might there be a period of underperformance? We also looked at, for funds that ultimately underperformed their benchmarks over a 15-year period, how long might have there been a period of overperformance? Now when I am saying a period of overperformance or a period of underperformance, what I mean is a period in which at the very end of the period the investor would have been better off in the index fund that tracks the benchmark than they were at the beginning of the period. And what I mean by a period of outperformance is a period in which the investor would have been better with the active fund than with the benchmark index at the end of the period relative to the beginning of the period. Within these periods of underperformance and outperformance there can be ups and downs.

Charest: Which types of funds did the study look at?

Dr. Kaplan: We looked at actively managed equity funds. We looked at U.S. funds, Canadian funds, UK funds and funds in a few other places as well.

Charest: Intuitively, because we tend to think of returns as fairly constant, we may assume that funds that have been successful over a 15-year period would have had very short periods of underperformance. Was that the case?

Dr. Kaplan: No, in fact that was not the case at all. And what we found was that on average funds that outperformed over a 15-year period had an average of about 9 years of underperformance. We also found that funds that ultimately underperformed their benchmark, ultimately had an average outperformance period of 11 years.

Charest: How is it possible that funds that end up being successful over a long period have such long stretches of underperformance and vice versa?

Dr. Kaplan: Well because when we say that a fund has outperformed its benchmark, say over 15 years, by some amount, it doesn't mean they consistently year-in and year-out outperformed. There are going to be stretches of underperformance, stretches of outperformance and all they are saying is that at the end of 15 years -- even though they ultimately outperformed, they could have had these long stretches of underperformance.

Charest: Did you observe that for the top performers as well, or was it more concentrated on the middle performers?

Dr. Kaplan: We did find that when we looked at the outperformers, the greatest outperformers -- the ones that had the highest level of outperformance versus the ones that had the least -- there definitely was a pattern that those funds which had the highest level of outperformance had the shortest periods of underperformance. Looking at the top 10% of all funds in our sample. The average period of underperformance was still 6 years which of course is still longer than typically the period used to evaluate a fund.

Charest: So, what does this mean for investors and their advisors who are trying to pick mutual funds. If we see that a particular fund has underperformed its benchmark over, say, a 5-year period, which is a standard period that people use to evaluate performance; if we see that it's underperformed its benchmark we may conclude that it's a bad fund, but it may simply be going through one of its dry spells and end up being a winner over the long term. So does this mean that past performance is basically useless to look at as a predictor?

Dr. Kaplan: Well to answer that question would go well beyond what we covered in this study. We were just looking at periods of longest under- and longest outperformance within the 15-year sample. I really can't answer that question completely, but what I can say is that it does show that any investor in an active fund really may need to be prepared to have a lot of patience. Because it may take a while before a fund that ultimately is going to outperform, they may have to go through a substantial period of underperformance.

Charest: So, this makes the job of picking active funds a lot harder than some people may have thought since past performance is the data point that's the most easily and readily available. So, what would the recommendation be then for investors?

Dr. Kaplan: Well as you mentioned in the introduction. We do have the disclaimer that past performance is no guarantee of future performance, and I think what this study does is it says we really have to… that it's a really important point. Because as we were saying you may be looking at a fund that's just going through a dry spell and later it may outperform. So, you can't just go by past performance.

What else can you look at? Well there is probably a lot of other things you can take a look at the fund. I mean what do you know about the fund manager? What tenure does the fund manager have? How long have they been running the fund? And there are just a number of different aspects of funds that go beyond just the performance record that might give you reason to believe that you are looking at fund that's being managed by a skilled manager.

Charest: And as you mentioned it's essential to have patience and look at long periods.

Dr. Kaplan: That's right. Because I think what this study shows is that even if I could say I have identified this particular manager, he is a great manager and I am expecting over the long run to outperform the benchmark for that fund, you may need a lot of patience, and you have to be willing to go through those dry spells.

Charest: And for those who don't have that patience?

Dr. Kaplan: Well if you don't have the patience that's necessary to go with active management then of course you always have the alternative of passive index funds.

Charest: Good advice Paul. Thank you very much for sharing your thoughts with us today.

Dr. Kaplan: Thank you.

Charest: And for Morningstar, I'm Christian Charest. Thank you for watching.

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