By Todd Rosenbluth, CFRA
The average investor has heard the message so often that they can finish the sentence for us: past performance is not indicative of… CFRA’s fund research puts this warning into practice, by focusing on costs and holdings. Yet, for those that still plow ahead chasing prior winners, semi-annual research from S&P Dow Jones Indices serves as a cautionary tale.
For the three years ended March 2017, the persistence scorecard showed that just 23% of large-cap funds, 11% of mid-cap funds and 22% of small-cap funds maintained a top-half ranking for two additional consecutive 12-month periods (performance is based on equal weighted fund counts). Random expectations, such as using a two-sided coin, would suggest a rate of 25%.
This data supports why investors have shifted billions of dollars from active US equity strategies to passive strategies. Products such as iShares Core S&P 500 (IVV) or Vanguard Large-Cap Index (VV) are available with net expense ratios of 0.04% and 0.06%, respectively.
Further, active fund advocates need to be mindful that the once hot active mutual funds (those in the top quartile) might very well end up in the bottom quartile soon after. According to the S&P Dow Jones study, of 370 domestic equity funds that were in the top quartile, 28% moved into the bottom quartile during the five-year horizon. Meanwhile, for bottom quartile funds that did not get merged or liquidated, 17% moved to the top quartile over the same period.
We contend that part of the underperformance of an actively managed fund stems from its expense ratio. While the average large-cap core mutual fund has a 1.1% expense ratio, there are many funds with lower costs. Since expense ratios eat into investor returns, choosing strong performing funds that cost less increases the likelihood of consistent gains.
For example, Vanguard Growth & Income Fund (VQNPX), a CFRA five-star fund, outperformed its large-cap core peers for the seventh straight year. VNQPX has a below-average standard deviation and incurs a modest 0.34% net expense ratio. Many fund holdings, including Johnson & Johnson (JNJ) and JP Morgan Chase (JPM) are viewed by CFRA as being both attractive and of high quality. Year to date through June 13, the fund is modestly lagging its peers.
T Rowe Price Dividend Growth (PRDGX), another CFRA five-star fund, outperformed its large-cap core peers for three consecutive years, aided by its low 0.64% expense ratio; year to date the fund is ahead of its peers. However, PRDGX underperformed this same group in 2012 and 2013, highlighting the challenges of ignoring funds that lag their peers. Here too appealing holdings, including Comcast (CMCSA) and PepsiCo (PEP), help the fund’s ranking.
While the S&P Dow Jones Indices data is not favorable toward active mutual funds, we believe investors can either find funds with a combination of strong attributes or join the trend to low-cost passive investing.
Todd Rosenbluth is Director of ETF & Mutual Fund Research at CFRA.