“On Persistence in Mutual Fund Performance” Carhart (1997)

by vonNudge

“Past performance is not indicative of future returns” is a familiar tag-line to investors, but is it true? Other papers covered in this blog have shown that past returns are given a high weight in investors’ decision making processes, and that past returns moderate diversification bias. This paper shows that good past performance does in fact not indicate high future returns, but that the opposite can in fact be the case (if the performance is based on loading up on specific risk factors).

As with any good finance study (and hence my gripe with Borges et al., 1999), returns have to be compared to the expected returns from an asset pricing model. Taking more risk than the market is an easy way to outperform without necessarily displaying any skill. This paper uses a four factor model, which includes the Fama French value and size factors, as well as a momentum factor. Depending on your view of finance these factors can either be rationally priced risk factors or behavioural anomalies, but they do help to explain and predict performance better than the CAPM. Returns on these additional factors tend to wax and wane. The value premium might be very negative for many years, such as in the dot com bubble, and then suddenly reappear. This is why investing based purely on high raw returns is a bad idea, as it might have been from loading up on asset classes with specific risk factor sensitivities which will then mean-revert.

This paper shows that after correcting for these risk factors, that there is very little persistence in fund performance. For example, a fund could outperform the market by overweighting small-cap value stocks, but this does not reflect skill since it can be mimicked by a passive strategy. And in fact the only real unexplainable persistence in returns in this study is that of the worst mutual funds. Now, obviously there is such a thing as investment skill. Perfectly efficient markets are not possible. But can your average retail access obtain access to skilled managers, and can they obtain their services for less than the cost differential? Investing with a manager who can produce 1% of alpha a year is no use if their marginal cost is 1.5% a year. My intuition, and the fact that high-performing hedge funds such as Renaissance Technologies do not accept any investor capital at all, suggests otherwise. Retail investors are much more likely to end up with the managers that are persistently bad.

This study also suggests that high-fee funds actually underperform by more than their cost differential. Increasing fees by 1% tends to decrease returns by 1.54%. Funds that charge a load (a sales charge to invest in the fund) also perform worse, even before accounting for the higher fees.

So why are investors so fixated on a piece of noisy information, while ignoring information – investment costs – which provide a true signal? It might be that the current presentation of fees is simply too abstract and too far removed from most investors’ experience of consumer decision making. Given that it is hard to evaluate fees, investors heuristically give up on evaluating them and “take the best” by focusing on past returns. My hypothesis is that changing the presentation of fees, by making them more salient, might help investors incorporate them into their decision making. Past returns are, after all, not indicative of future returns, so reducing this bias could do a lot of good.