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I am a looking at a specific fund that made a killing last year. I know that this is a speculative question, but I am interested whether what I am saying held true over the years. Does a mutual fund that perform really well one year tend to do bad the following year? What evidence is there?

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I suggest you search on "sector rotation." Jerry's answer is great, and hit 3rd bullet addresses my observation. The fund you cite isn't general, but a sector. Can one sector be hot2 years running? –  JoeTaxpayer Feb 19 at 18:33
    
Looks like a few categories did well last year, looking at bespokeinvest.com/thinkbig/2013/12/31/… –  JB King Feb 19 at 18:47
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If I could answer that question, I wouldn't be here answering questions. I'd be driving around in my Ferrari in my living room. –  JohnFx Feb 19 at 21:17
    
@JohnFx I understand that we are not oracles, but surely someone has compiled these stats and has used them to their advantage. –  AngryHacker Feb 20 at 5:07
    
Statistics helps you in making a decision, and it doesn't make a decision. So statistically improbable events also may occur, not that they will occur with surety. –  DumbCoder Feb 20 at 8:54
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3 Answers

This can be answered by looking at the fine print for any prospectus for any stock, bond or mutual fund. It says: "Past performance is not an indicator of future performance.".

A mutual fund is a portfolio of common stocks, managed by somebody for a fee. There are many factors that can drive performance of a fund up or down. Here are a few:

  • The fund may change managers
  • The portfolio mix within the fund may change
  • The group of stocks on which the fund is based may be come this year's hot ticket or cold turkey
  • Government policies (fiscal, regulatory, local, national, international) may change at any time
  • "Stuff" may happen to the individual companies. Nortel, as an example, was at the core of many tech funds when it collapsed, killing those funds
  • "Stuff" may happen within the country that drastically affects the price of the fund. Remember the market crash following Sept. 11, 2001 in the United States?
  • The individual companies within the fund may have good luck or bad luck. Sudden increase in orders, class action lawsuits, labour issues, corruption and firings in senior management are just a few that come immediately to mind
  • Some savvy trader or computer program is directly manipulating the market. An institutional selloff below market value can trigger a flash crash, which triggers sell stops created by retail investors, for example, allowing the institution to purchase the assets freed up by the triggering of the sell stops.
  • Some savvy investors are cornering the market on a commodity to drive up the price so they can exit their position and profit, leaving everyone else with a loss. Remember the Hunt brothers and their silver shenanigans?

I'm sure there are many more market influences that I cannot think of that push fund prices up or down. What the fund did last year is not one of them. If it were, making money in the mutual fund market would be as easy as investing in last year's winners and everyone would be doing it.

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Nearly all long-lived active funds underperform the market over the long run.

The best they can hope for in almost all cases is to approximate the market return.

Considering that the market return is ~9%, this fund should be expected to do less well.

In terms of predicting future performance, if its average return is greater than the average market return, its future average return can be expected to fall.

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From a mathematical point of view the stats do not change depending on past performance. Just because a fund is lucky one year doesn't mean that it will be unlucky the next.

Consider tossing a coin, the chance of heads is 50%. If you have just thrown 3 heads, the chance of heads is still 50%. It doesn't go down.

If you throw 10 heads in a row the chance of a heads is still 50%, in fact you many suspect there is something odd about the coin, if it was an unfair coin then the chance of a heads would be higher than 50%.

It could be the fund is better run, but there could be other reasons, including random chance. Some funds will randomly do better and some will randomly do worse

What you do know is that if they did better than average other funds have done worse, at least for last year.

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Right on the money. We can see this with SVXY: in 2011 it had a good year. It also had a great year in 2012 and 2013. I feel bad for those thinking that its odds for success decreased in subsequent years following its good 2011 year. See finance.yahoo.com/… for details. –  Question3CPO Feb 20 at 13:32
    
Of course you could give the same answer to the question, "Does a person/team that did well at sport last year tend to do well next year?". Obviously there's some correlation. There is a random component to performance, there's also real skill. The question then, is whether fund performance involves any skill at all, and even if so whether the market has already factored it so that current price is based on expected performance given what we know about the fund managers, such that any deviation from average performance is indeed random anyway :-) –  Steve Jessop Feb 20 at 15:48
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