A rugby team that has won a lot of games this year is likely to do fairly well next year: they’re probably a good team. Someone who has won a lot of money betting on rugby this year is much less likely to keep doing well: there was probably luck involved. Someone who won a lot of money on Lotto this year is almost certain to do worse next year: we can be pretty sure the wins were just luck. How about mutual funds and the stock market?
Morningstar publishes ratings of mutual funds, with one to five stars based on past performance. The Wall Street Journal published an article saying (a) investors believe these are predictive of future performance and (b) they’re wrong. Morningstar then fought back, saying (a) we tell them it’s based on past performance, not a prediction and (b) it is, too, predictive. And, surprisingly, it is.
Matt Levine (of Bloomberg; annoying free registration) and his readers had an interesting explanation (scroll way down)
Several readers, though, proposed an explanation. Morningstar rates funds based on net-of-fee performance, and takes into account sales loads. And fees are predictive. Funds that were good at picking stocks in the past will, on average, be average at picking stocks in the future; funds that were bad at picking stocks in the past will, on average, be average at picking stocks in the future; that is in the nature of stock picking. But funds with low fees in the past will probably have low fees in the future, and funds with high fees in the past will probably have high fees in the future. And since net performance is made up of (1) stock picking minus (2) fees, you’d expect funds with low fees to have, on average, persistent slightly-better-than-average performance.
That’s supported by one of Morningstar’s own reports.
The expense ratio and the star rating helped investors make better decisions. The star rating and expense ratios were pretty even on the success ratio–the closest thing to a bottom line. By and large, the star ratings from 2005 and 2008 beat expense ratios while expense ratios produced the best success ratios in 2006 and 2007. Overall, expense ratios outdid stars in 23 out of 40 (58%) observations.
A better data analysis for our purposes would look at star ratings for different funds matched on fees, rather than looking at the two separately. It’s still a neat example of how you need to focus on the right outcome measurement. Mutual fund trading performance may not be usefully predictable, but even if it isn’t, mutual fund returns to the customer are, at least a little bit.
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