Vanguard’s presentation on quantifying the impact of chasing fund performance.
H/T Barry Ritholtz
The lure of performance-chasing
The refrain “Don’t just sit there, do something!” has become part of daily life. The phrase exhorts us to take action to bring about a change. For investors experiencing below-average mutual fund returns, this advice may seem reasonable. The resulting action plan for such investors frequently involves moving assets from one fund to another fund with a stronger performance track record over the past few years. In short, these investors end up chasing performance.
Research has shown that performance-chasing is not restricted to specific groups or sub-segments of investors; rather, both retail and institutional clients have shown an inclination to chase performance (Goyal and Wahal, 2008; Bennyhoff and Kinniry, 2013). Given the intuitiveness and popularity of this behavior, we decided to take a closer look at its underlying assumptions and historical performance.
In theory, performance-chasing succeeds if past performance can predict future performance. In financial terms, performance-chasing may provide a benefit if there is persistent (that is, repeated and prolonged relative outperformance from year to year.
By performance-chasing, investors implicitly or explicitly assume that performance persistence is fairly strong.
In contrast, investors who follow a buy-and-hold strategy are assuming that performance persistence is fairly weak and that excess returns are not likely to be gained by chasing performance. This research note compares performance-chasing with buy-and-hold by comparing the returns and risk-adjusted performance of each strategy to determine if taking action based on past performance is worthwhile.
Performance-chasing: Study sample and ground rules
For our primary analysis we chose the universe of active U.S. equity mutual funds available in any of the nine equity style boxes in Morningstar’s database during the ten years ended December 31, 2013. After filtering the database to include only funds in existence for a minimum of three calendar years at some point during the analysis period, we arrived at a study sample of 3,568 funds.
To compare performance-chasing with buy-and-hold, it’s essential to define the trading/investment rules governing each strategy through time. We settled on a set of rules as a reasonable representation of actual investor behavior related to each strategy. Using these rules as part of a quantitative historical simulation for the period 2004–2013, we examined the performance of each possible path an investor could have taken within the trading-rule guidelines. We performed the analysis separately in each of the nine equity style boxes to control for size or style influences that might affect the results. Our simulation produced a total of more than 40 million return paths.
Trading/investment rules for this analysis
Initial investment: At the start of the analysis period, we invested in any fund in existence for the full three-year period from 2004 through 2006 that had an above-median three-year annualized return.
Sell rule: Using three-year rolling periods of returns, we moved forward one calendar year at a time. Funds that achieved below-median three-year annualized returns at any time were sold, as were funds that were discontinued.
Reinvestment rule: After any sale, we immediately reinvested in each fund that achieved an average annualized return within the top-20 performing funds in the style box over the prior three-year rolling period.
Initial investment: Invest in any fund.
Sell rule: Sell only if a fund is discontinued.
Reinvestment rule: Reinvest in the median-performing equity mutual fund within the relevant style box.
Performance-chasing: Advantages of the methodology
This process of cycling through the performance-chasing and buy-and-hold trading rules generated millions of potential return paths that could have been experienced by investors during the period 2004–2013. Using these return paths, we were able to calculate the median experience as well
as the full distribution of potential outcomes for investors engaged in each type of strategy.