Performance persistence

What Is Performance persistence?

Performance persistence refers to the tendency of an investment, fund, or manager to maintain a similar level of performance—whether good or bad—over successive periods. Within the realm of investment management, understanding performance persistence is crucial for investors and researchers alike, as it speaks to whether past success or failure is indicative of future results. Essentially, it examines if "hot hands" or "cold streaks" are a genuine phenomenon or merely a product of random chance. The concept challenges the idea that market movements are entirely unpredictable and that outperformance is solely due to luck.

History and Origin

The study of performance persistence gained significant academic attention in the mid-1990s, particularly within the context of mutual funds. While earlier studies hinted at its existence, a seminal paper published in 1997 by Mark Carhart, titled "On Persistence in Mutual Fund Performance," is widely considered a cornerstone in the field. Carhart's research, which analyzed U.S. equity mutual funds from 1962 to 1993, explored whether past returns could predict future performance. He found some short-term performance persistence, particularly over one-year periods, but concluded that it largely disappeared over longer horizons when accounting for various factors. Ca²⁵rhart attributed much of the observed short-term persistence to common factor models in stock returns, such as market risk, size, value, and importantly, momentum, rather than inherent managerial skill. Ot²², ²³, ²⁴her academic works, such as the 1995 paper "Performance Persistence" by Stephen J. Brown and William N. Goetzmann, also significantly contributed to the understanding of this phenomenon, particularly noting persistence in relative risk-adjusted performance, often driven by poorly performing funds.

#²⁰, ²¹# Key Takeaways

• Performance persistence investigates whether past investment returns are predictive of future returns.
• Studies generally show limited evidence of long-term performance persistence, especially for active managers, once factors like risk and expenses are considered.
• Short-term persistence, particularly the underperformance of poorly performing funds, has been more consistently observed.
• Many observed patterns in performance persistence can be attributed to factors such as investment style, risk exposure, and costs, rather than persistent manager skill.
• Investors are often cautioned by regulators against relying solely on past performance as an indicator of future results.

Interpreting Performance Persistence

Interpreting performance persistence involves assessing whether an investment's historical return on investment pattern is likely to continue into the future. For active managers, true performance persistence would imply that a manager's skill consistently generates alpha—returns in excess of what would be expected given their benchmark and risk-adjusted returns.

Researchers typically measure performance persistence by sorting funds or investment strategies into quantiles (e.g., deciles or quintiles) based on their past returns over a specific lookback period. They then observe the subsequent performance of these groups over a holding period. If, for instance, funds in the top quintile consistently remain in the top quintile, or those in the bottom quintile stay at the bottom, then persistence is said to exist. However, many studies, including research by Morningstar, suggest that while there might be some short-term persistence, particularly among U.S. equity funds, this is often attributable to exposure to momentum stocks rather than distinct manager skill. Over longer horizons, a meaningful relationship between past and future fund performance is less evident.

¹⁹Hypothetical Example

Consider two hypothetical active portfolio management strategies, Alpha Fund and Beta Fund, over a two-year period.

Year 1 Performance:

• Alpha Fund: +15%
• Beta Fund: -5%

Analyzing for Persistence:
At the end of Year 1, an investor observes the significant difference in performance. If performance persistence were strong, one might assume Alpha Fund would continue to outperform and Beta Fund would continue to underperform.

Year 2 Performance:

• Alpha Fund: +3%
• Beta Fund: +8%

In this simplified example, the strong performance of Alpha Fund in Year 1 did not persist into Year 2. Conversely, Beta Fund, which performed poorly in Year 1, saw an improved performance in Year 2. This scenario illustrates that past performance, even if significantly different, does not inherently guarantee future results. Factors such as a shift in market conditions, changes in investment strategy, or even random market fluctuations could explain the lack of persistence. This highlights why investors are often advised to consider more than just a fund's short-term track record when making decisions about their asset allocation.

Practical Applications

Understanding performance persistence has several critical practical applications for investors and financial professionals:

• Investor Decision-Making: Investors are frequently advised not to chase past performance when selecting investments. The U.S. Securities and Exchange Commission (SEC) explicitly cautions investors that a fund's past performance is "no guarantee of its future success" and encourages looking at factors beyond just past returns, such as fees, expenses, and a fund's risk tolerance. Rely¹⁷, ¹⁸ing solely on a "hot" fund's past returns can lead to disappointing results if that performance does not persist.
• Fund Selection and Due Diligence: For financial advisors and institutions performing due diligence, evaluating performance persistence helps distinguish between genuine skill and mere luck. While some short-term persistence can exist, often attributed to market factors like momentum, consistent long-term outperformance is rare. This¹⁶ pushes practitioners to scrutinize other elements, such as the consistency of an investment strategy, the manager's experience, and the fund's expense ratio.
• Regulatory Scrutiny: Regulatory bodies, like the SEC, monitor how investment performance is advertised to prevent misleading claims. They require disclosures that past performance does not indicate future results, reflecting the general lack of strong, reliable persistence in the broader market.
• ¹⁴, ¹⁵Private Equity vs. Public Equity: Interestingly, while studies on public equity funds (like mutual funds) often find limited persistence, research suggests there might be more evidence of performance persistence in private equity, particularly among top and bottom performers. This is sometimes attributed to factors like skill in identifying better investments or the ability to add value post-investment. A 20¹³08 paper on performance persistence in institutional investment management also found varying degrees of persistence across different asset classes, with some evidence in international equity and fixed income portfolios, although persistence in domestic equity tended to fade after one year.

¹²Limitations and Criticisms

Despite extensive research, the concept of performance persistence faces several limitations and criticisms:

• Survivorship Bias: Many early studies on performance persistence were criticized for not accounting for survivorship bias. This bias occurs when studies only include funds that have survived and continue to exist, often excluding those that have failed or merged due to poor performance. This can create an illusion of persistence, as only the successful funds remain in the sample, leading to an overestimation of actual persistence.
• ¹⁰, ¹¹Attribution of Performance: A significant critique, notably highlighted by Carhart (1997), is that much of the observed short-term persistence can be explained by common factor models (e.g., market, size, value, and momentum) rather than the individual skill of a fund manager. This suggests that funds perform well not because of superior stock-picking ability, but because their underlying holdings happen to align with currently successful market factors.
• ⁸, ⁹Fee and Expense Impact: High expense ratios and trading costs can erode any potential persistence in gross returns, turning otherwise persistent outperformance into underperformance for investors after fees. Even⁷ if a manager possesses skill, the costs associated with active management can negate any sustained advantage.
• Dynamic Market Conditions: Market environments are constantly changing, and an investment strategy that performs well in one set of conditions may not in another. This dynamic nature makes it challenging for any manager to maintain consistent outperformance over long periods.

Performance Persistence vs. Market Efficiency

Performance persistence and market efficiency are two concepts in financial economics that are often discussed in relation to each other, representing different perspectives on whether it's possible to consistently "beat the market."

Market efficiency, particularly in its strong and semi-strong forms, posits that asset prices fully reflect all available information. A direct implication is that it is impossible for investors to consistently achieve risk-adjusted returns superior to the overall market through stock picking or market timing, because any new information is immediately incorporated into prices. Under this hypothesis, any observed outperformance would be purely coincidental or due to taking on higher, uncompensated risk.

Performance persistence, on the other hand, investigates whether superior (or inferior) returns do continue over time. If strong performance persistence existed reliably, it would challenge the notion of fully market efficiency, implying that certain managers or strategies possess a lasting advantage or "skill." However, as many studies conclude that significant long-term performance persistence is largely absent, especially after accounting for risk factors and costs, these findings often lend support to the principles of the efficient market hypothesis. The consensus leans towards the idea that while short-term "hot streaks" might appear, they are often difficult to sustain and are frequently explained by factors other than genuine, persistent managerial skill.

FAQs

Q1: Does past fund performance guarantee future returns?
No, past fund performance does not guarantee future returns. Regulatory bodies, like the SEC, explicitly state this, and numerous studies confirm that relying solely on historical returns is not a reliable predictor of future success.

Q⁵, ⁶2: Why do some funds seem to perform well year after year?
While some funds may show short-term strong performance, this is often attributable to their exposure to specific market factors like momentum, a particular investment strategy aligning with current market trends, or simply good luck. It is challenging for managers to consistently outperform over long periods after accounting for all risks and costs.

Q³, ⁴3: Is performance persistence more common in certain types of investments?
Research suggests that the degree of performance persistence can vary across asset classes. While it's less consistently found in traditional mutual funds (public equity), some studies indicate more evidence of persistence in less liquid or less efficient markets, such as private equity.

Q²4: How should investors use information about performance when making decisions?
Investors should view past performance as just one piece of the puzzle. It's more important to understand a fund's investment strategy, its associated risks, its expense ratio, and how it fits into their overall diversification and financial goals. A fund's consistency in adhering to its stated strategy might be a more valuable indicator than raw past returns alone.

Q5: What is the main reason for a lack of long-term performance persistence?
The main reason for the observed lack of long-term performance persistence in many liquid markets is that any informational advantage or superior skill possessed by managers is often quickly arbitraged away by other market participants. Additionally, factors like fees, transaction costs, and market efficiency tend to normalize returns over time, making consistent outperformance difficult to sustain.¹