Paul Kaplan

The typical procedure in fund performance evaluation consists of setting a time period in advance—say three, five, or 10 years—and then calculating some investment statistics over that period. Whether the fund outperformed or underperformed its benchmark is usually the focus of the analysis.

In a recent study, Maciej Kowara and I inverted this procedure. Rather than asking whether the fund outperformed or underperformed over a given period, we studied the longest period of underperformance.

To be more concrete, let’s assume we can confidently establish that a fund that follows a given strategy will outperform its benchmark over the long run. Even such a fund will have subperiods of underperformance. If an investor has the misfortune of investing in that fund at the beginning of such a period, how long will he or she, in the worst-case scenario, need to wait for the fund to catch up with the benchmark? In other words, how long can a good fund underperform? (Note: Within a period of underperformance, there could be subperiods of outperformance.)

Maciej and I sought to answer this question using historical returns on actively run mutual funds and by running Monte Carlo simulations. We collected returns on thousands of funds globally from January 2003 to December 2017. We sorted these funds by 15-year return in excess of the fund-specific benchmark.

What we found when we looked at how long a good fund can underperform 

Looking at the top 10% of funds by excess return, we found that investors might have endured on average almost six years of underperformance. That’s a level of patience many investors are unlikely to possess. Our Monte Carlo results confirm the finding that investors in the best of funds may need great levels of patience. 

Even if performance statistics are done correctly and interpreted properly, they only tell half the story. The lengths of periods of underperformance are part of the other half. While funds that should outperform their benchmarks over the long run may be desirable, they might not be suitable for investors with limited patience.

We found that, on average, funds that outperformed over a 15-year period had an average of about nine years of underperformance. We also found that funds that ultimately underperformed their benchmark, had an average outperformance period of 11 years.

Do funds that are successful over a long period have long stretches of underperformance? 

When we say that a fund has outperformed its benchmark over 15 years by some amount, it doesn't mean it consistently year in and year out outperformed. There are going to be stretches of underperformance and stretches of outperformance. And all they are saying is that, at the end of 15 years—even though they ultimately outperformed their benchmarks—they could have had these long stretches of underperformance.

A reminder that past performance is no guarantee of future performance

Morningstar, and the whole industry, has the disclaimer that past performance is no guarantee of future performance. This study really drives that point home. An investor may be looking at a fund that is going through a dry spell but later that same fund may outperform—an important reminder that investors can't judge a fund on past performance.