Is past performance a useful indicator of future performance for some kinds of mutual funds? In their April 2014 paper entitled “Differences in Short-Term Performance Persistence by Mutual Fund Equity Class”, Larry Detzel and Andrew Detzel evaluate performance persistence among diversified U.S. equity mutual funds categorized per the Morningstar Equity Style Box: Large Value (LV), Large Blend (LB), Large Growth (LG), Mid-Cap Value (MV), Mid-Cap Blend (MV), Mid-Cap Growth (MG), Small Value (SV), Small Blend (SB) or Small Growth (SG). Each quarter, they sort funds into styles and then rank them into fifths (quintiles) based on four-factor alpha (adjusting for market, size, book-to-market and momentum risks) calculated with daily returns. They then calculate average four-factor alphas for these quintiles during the next four quarters. Using quarterly Morningstar style assignments and daily returns for a large sample of live and dead diversified U.S. equity mutual funds, along with data for associated stocks and contemporaneous returns for risk factors, during January 1999 through December 2011, they find that:
- When ranking all funds together (regardless of style), performance persistence is evident only for the worst performers.
- The top quintiles of SV and MV demonstrate reliably positive next-quarter average annualized alphas of 4.1% and 2.7%, respectively.
- The top quintiles of LB, LG, MG and SG have negative next-quarter average alphas.
- Bad performance typically persists for at least four quarters across styles. Superior performance decays more rapidly, except for SV, within which outperformance persists for at least four quarters.
- Liquidity risk does not fully explain outperformance persistence within styles. Adding a liquidity factor to the four-factor model reduces next-quarter average annualized alpha of top SV and MV quintiles only modestly to 3.7% and 2.6%, respectively.
- Restricting the sample to no-load funds (to eliminate trading frictions) has no material effect on next-quarter average alphas for top SV and MV quintiles.
In summary, evidence indicates that investors can use past performance to identify exploitable near-term outperformance by focusing on (no-load) small-capitalization value and mid-capitalization value funds.
Cautions regarding findings include:
- The sample period is not very long (13 years) in terms of potentially underlying equity style cycles.
- Individual investors generally do not hold enough mutual funds to achieve quintile-like reliability.
