Why it doesn't pay to chase fund performance

One of the most important investment decisions you make is in determining your asset allocation, or how you choose to divide your assets between risky and safe investments. Another key decision concerns which strategy to use when selecting the funds to implement your asset allocation plan. Should you be a buy-and-hold investor? Or should you rely on recent performance to select funds?

Vanguard's research team examined exactly this question in a July 2014 study, "Quantifying the Impact of Chasing Fund Performance."

Vanguard notes that chasing performance isn't limited to individuals. Most institutional investors do so as well. Unfortunately, studies on pension plan sponsors have found that the managers who were fired actually go on to outperform their replacements. Yet, despite this and other evidence demonstrating the lack of persistence in outperformance beyond the randomly expected, chasing prior returns must have a strong allure because investors keep doing it.

To try quantifying the costs of performance chasing, Vanguard used Morningstar's database to examine the universe of active U.S. equity mutual funds available in nine equity style boxes for the 10 years ended Dec. 31, 2013. They limited the database to funds in existence for a minimum of three calendar years at some point during the analysis period, arriving at a study sample of 3,568 funds.

They defined the rules for the performance-chasing strategy in the study as follows:

Initial investment: At the start of the analysis period, invest 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, move forward one calendar year at a time. Sell funds that achieved below-median three-year annualized returns. Sell funds that were discontinued.

Reinvestment rule: After any sale, immediately reinvest 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.

Note that the study used a three-year period because that length of time matches well with the typical holding period for mutual funds. It also matches the typical evaluation period for institutional investors.

The study's rules for the buy-and-hold strategy were, at the start, to invest in all funds. Sales took place only if a fund was discontinued. Reinvestments from discontinued funds were reinvested immediately in the median-performing fund in the relevant style box.

Here's a summary of Vanguard's findings:

• The buy-and-hold strategy was the superior performer in all nine Morningstar style boxes.
• The average outperformance by the buy-and-hold strategy was 2.8 percent, with the gap in returns between the two strategies ranging from 1.6 percentage points (for mid-cap value funds) to 4 percentage points (for mid-cap blend funds).
• The Sharpe ratios (a measure of risk-adjusted performance) for the buy-and-hold strategy were also higher in all nine style boxes, with an average outperformance of 0.12.

The results are particularly striking when you consider that the study doesn't take into account any costs, either transaction costs or, for taxable accounts, the cost of tax payments. Moreover, for taxable accounts, we should expect to see a large advantage for the buy-and-hold strategy. Even more important -- because we know index funds outperform the vast majority of actively managed funds over the long term, especially after taxes -- if Vanguard had compared the performance-chasing strategy to a buy-and-hold indexing strategy, the results would have been even more compelling.

The bottom line is that while performance-chasing seems to be an all-too-human trait, if you're ever tempted by the recent record of a "hot" fund manager, remember that you cannot buy yesterday's outperformance, only tomorrow's returns.

And, as the evidence in this study demonstrates, when tempted to chase performance, the best thing an investor can do is follow this advice: "Don't do 'something,' just sit there."

The only caveat is that this advice assumes you're holding index funds or other passively managed funds. If you're holding actively managed funds, sitting there and doing nothing is still superior to performance chasing. However, the winning strategy would be to do a specific something: Switch to passively managed funds first, and then be a buy-and-hold (and rebalance) investor.