Which fund would you pick if you saw the following data?
If you’re like most people, you would choose ABC because it performed better during the past five years. Not many people would be persuaded to buy a fund that has recently lost money. But is that really the wisest way to construct your portfolio?
The example above isn’t hypothetical. It's based on research from Morningstar. They divided up thousands of U.S. equity mutual funds into quartiles based on their average management expense ratio (MER) and then again into quartiles based on their performance from 2000 to 2005, creating 16 individual groupings of mutual funds.
ABC represents the average characteristics of the best performing funds in the most expensive group while XYZ represents the worst performing funds in the cheapest group of funds.
Morningstar then calculated the performance of these funds from 2005 to 2015 to see which factors gave the best insight into future performance.
What did they find?
Funds that had the characteristics of ABC went on to return an average of 5.5% a year over the next 10 years. Funds that had the characteristics of XYZ, meanwhile, went on to return 7.4%. For context, the flagship U.S. stock market index, the S&P 500, earned 7.3% annually during the same stretch.
This is more evidence of why you should keep your costs low. Researchers agree: the costs a fund incurs (both from management fees and implicit trading costs) are the single best predictor of how well it will fare relative to its peers in the future. Low-cost funds are much more likely to do better and high cost funds are much more likely to do worse. This is why Wealthsimple builds portfolios using low-cost passive investment funds.
Another interesting takeaway from Morningstar's work is that past performance really doesn’t predict future performance: it’s not just a disclaimer. In fact, to the extent past performance is correlated with future performance at all, it seems to be inversely. The accompanying chart shows that even among funds of similar cost, those that had performed best from 2000 to 2005 subsequently did worse than the funds that had performed poorly. This was true in every fee quartile.
One possible explanation for this seemingly counter-intuitive finding is that the funds that performed best from 2000 to 2005 owned assets whose valuations had become elevated. This is the very reason they performed so well, but it also may have set them up for poor subsequent performance. Conversely, the funds that had lousy performance may have owned assets that fell out of favour with the market and became more attractively valued. This set them up for improved future performance.
The common practice of selecting funds based on past performance is likely to leave you disappointed. Focus on what research shows actually matters. Build a well-diversified portfolio of the lowest-cost funds (preferably passive mutual funds) and stick with them through the ups and downs, periodically rebalancing along the way.