By Cavanaugh Asset Management

Mutual fund returns are notoriously inconsistent. This makes it difficult to select those funds which will outperform going forward. In 1997, Mark Carhart published a study in the Journal of Finance on consistency of mutual fund returns. Over a 31-year period, he ranked each fund annually by total return. He determined that 83% of the top decile funds fell from that position in the following period. He also found that the bottom 10% remained in that bottom decile 46% of the time. Other than those two groups, all other rankings showed no pattern. He theorized that many of the worst funds are throttled by high fees and therefore cannot gain ground. The high flying funds, on the other hand, are likely to be highly-concentrated, and therefore annual returns will be volatile. Outperforming funds are also often flooded with new deposits, making the fund more difficult to manage.

CCM also did a similar study, looking at mutual funds ranked in the top 25% for a given year. We tracked actively-managed mutual funds in the large cap, small/mid-cap, and international arenas and examined how well the funds did the year after they landed in the top quartile.

These graphs illustrate the results of our study. The red bar represents the percentage of time a fund improved its ranking the year after landing in the top quartile. The green bar shows the percentage of funds that dropped in the rankings.

The blue bar represents the percentage of funds that did not remain in the top 25%. The yellow bar represents those that did not even remain in the top half.

On average, 83% of large cap funds declined in ranking the year after finishing in the top quartile. A striking 42% fell completely out of the top half, on average.

Small and mid-cap mutual funds tell a similar story. In this sector, an average of 87% of funds declined and 48% fell out of the top half.

International funds, one area where opponents of indexing are most adamant, showed the same lack of consistency as with domestic funds. 84% of top quartile international funds declined the following year, and 45% fell out of the top half. Investors have no way of determining which funds will perform well, and therefore incur significant underperformance risk by selecting actively-managed funds.

Data as of 12/31/2000 from Moringstar

04/04/2001

This article is the property of Cavanaugh Asset Management, and is reprinted with permission. Cavanaugh Capital Management's mission is to provide equity clients with a diversified portfolio of index funds while also providing professional monitoring and reporting.