Past Performance and Future Results

“Past performance is no guarantee of future results.”

This is one of those legal incantations of gravity and vague importance that NYSE-Mod-Smallhave become so familiar that we do not fully appreciate the meaning. “You have the  right to remain silent.” is another example.

The past performance phrase is often spotted at the bottom of mutual fund ads. The rest of those ads, of course, generally do little else than tout past performance.

You cannot fault the fund companies for their focus on old return numbers. When you get down to it, there is not that much else to say about a mutual fund that would make good ad copy. Airbrushed glamour shots of the fund manager will not sell many shares.

Alas, the Wall Street Journal’s Fund Track column recently carried the argument, lifted from a recent academic paper, that the past performance disclaimer is obviously not adequate.

The professors ran a study in which they showed otherwise identical mutual fund ads with and without the phrase to 500 students. The presence of the warning about past performance had no effect on their opinions of the funds. This, the authors believe, is evidence that the disclaimer is a failure, since it is not doing what it should be doing, that is, talking people out of investing in mutual funds. Of course, the wisdom in the phrase is so commonplace it is hard to imagine that even a few of the 500 could have possibly been enlightened by reading it.

This discussion is timely because the Senate is currently working on a financial reform bill. The study authors want to strengthen the legally required disclaimer for mutual funds. They suggest “mutual funds that have outperformed their peers in the past generally do not outperform them in the future” although even that failed to warn off as many potential investors as they would have liked.

The subtext of all this is the belief that, outside of outrageous fees, mutual fund returns are fundamentally unpredictable and any advertizing that implies otherwise is misleading, if not fraudulent. From the WSJ article:

The problem, the critics say, is that performance ads broadly give the false impression that a fund’s past returns should be an important consideration. In fact, strong-seeming returns are almost always attributable to luck, so funds’ past performance is largely irrelevant, unlike other factors, such as investment fees, that do reliably influence long-term results.

Investors already know there are no guarantees, the study found, so the current label could be taken to mean strong past performance is a good indicator of future results—just not a promise of it.

But, as any serious student of the subject can tell you, many empirical studies have shown that past performance is indeed an indicator of future results. (The authors of this new study are, by the way, professors of law and accounting, not finance.) In other words, “mutual funds that have outperformed their peers in the past generally do not outperform them in the future” is wrong.

Whether or not past performance is a “good” indicator depends on your expectations. The relationship between past and future returns is weak, something you can only find by looking at thousands of funds over many years. But it is there and it is one of very few useful criteria available for picking funds.

The bottom line is that picking actively managed mutual funds, that is, selecting a manager who will outperform the market in the future, is a very hard thing to do, much harder than most people seem to realize. It is arguably harder than picking individual stocks, although the risks involved are much lower.

If I was a nanny-state liberal, I might believe that ordinary individuals should not be allowed to pick their own funds. On average it is a losing game, so as a public service it should be banned. Same goes for investments in general. These sorts of things should be left to professionals. Licensed professionals.

Of course, I am a libertarian and a capitalist. I believe people should be allowed to make well informed stupid decisions with their money. “Past performance is no guarantee of future results” is, it turns out, a fair and true statement that ought to have a significant impact on investor behavior. That it does not is justification for more books and blog posts, not more legislation.

No Comments

  • By Neil, April 26, 2010 @ 12:16 pm

    “If I was a nanny-state liberal”

    Straw man alert. Seriously, I’m a liberal, and a pretty left leaning one at that. I believe that the state has an important roll in backstopping people with basic necessities when they fail to provide them for themselves, and providing the resources so that a person future success isn’t predetermined by their parents’ success.

    Investing, not being a necessity, nor a service necessary to create equality of opportunity, is something that the state should regulate in such a way as to make it transparent and preventing fraud, but in the end has no role in protecting people from making their own decisions.

    I agree though, that past performance is not a guarantee, but is an indicator of future results. Therefore, the current wording is true and adequate.

  • By Rob Bennett, April 26, 2010 @ 4:39 pm

    The question is — how is past performance to be interpreted? Past performance is just a bunch of numbers. The same numbers can signify entirely different things to different people.

    Stocks prices have been going up hard for 10 years running. That’s past performance. Some view this as a good thing. Some view is as a bad thing (high prices mean poor performance on a going forward basis).

    It is re this question that the trickery comes in. People trying to sell stocks often suggest that 10 years of price increases is a good sign. Where the government should get involved is on the educational side of things. We need to educate investors about how The Stock-Selling Industry goes about tricking them into thinking that past performance means the opposite of what it really means.

    Education doesn’t hinder a free market — it sets it free. Educated investors make better-informed choices and better choices make for a better functioning market.


  • By Neil, April 26, 2010 @ 6:55 pm

    Rob – with mutual funds, this is less of an issue. With stocks (both individual and as a whole), consistent upward performance often leads to it becoming overvalued, as the less informed pile onto the bandwagon of something that’s moving up.

    Mutual funds issue more units when more people buy them. Their value depends on their underlying holdings, which change regularly as increasing values in some holdings bring them above their target weight. Consistent performance that exceeds their benchmark can be an indicator of either blind luck, or above-average management. But it’s not an indicator of being overvalued.

  • By jim, April 27, 2010 @ 2:58 pm

    The disclaimer is accurate and sufficient. Past performance is no *guarantee* of future performance. There is no *guarantee* in any kind of investment so saying this explicitly is just cluing in the clueless that if the fund averaged 12% in the past 5 years then that doesn’t mean it will get 12% next year. In my opinion past performance is a decent indicator (as good as any we have) of future performance.

    Making the disclaimers about fund performance meatier won’t change anything. Its like the warning on a pack of cigarettes. It will be headed or ignored. Having 2-3 paragraphs of legalize or scary warnings isn’t going to be any more impactful or effective then a clear concise single sentence.

    Neil is right the “nanny state liberal” comment is a straw man.

  • By mwarden, May 9, 2010 @ 9:51 pm


    Past performance is not a decent indicator of future results. The correlation is low and not reliable over time. I agree with Frank that it is worth *not ignoring* past performance when considering all features of mutual funds, but the point is that mutual fund information is constructed to give serious weight to past performance (this is the marketing angle Frank mentioned), and non-professionals consuming the information will always give too much weight to past performance. It sounds like even you are doing so.

    I also agree with Frank on the solution: education.

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