Chapter Eleven“Reversion to the Mean”

Yesterday’s Winners, Tomorrow’s Losers

IN SELECTING MUTUAL FUNDS, too many fund investors seem to rely less on sustained performance over the very long term (with all of its own profound weaknesses) than on superior performance over the short term. In 2016, over 150 percent of net investor cash flow went to funds rated four or five stars by Morningstar, the statistical service most broadly used by investors in evaluating fund returns.

These “star ratings” are based on a composite of a fund’s record over the previous three-, five-, and 10-year periods. (For younger funds, the ratings may cover as few as three years.) As a result, the previous two years’ performance alone accounts for 35 percent of the rating of a fund with a 10-year history and 65 percent for a fund in business from three to five years, a heavy bias in favor of recent short-term returns.

How successful are fund choices based on the number of stars awarded for such short-term achievements? Not very! According to a 2014 study by the Wall Street Journal, only 14 percent of five-star funds in 2004 still held that rating a decade later. Approximately 36 percent of those original five-star funds dropped one star, and the remaining 50 percent dropped to three or fewer stars. Yes, fund performance reverts toward the mean, or even below.

Reversion to the mean (RTM) is reaffirmed in comprehensive fund industry data.

Other data on fund returns confirm the power of RTM. Consider ...

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