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Does Past Performance Matter?

“Past performance is not an indicator of future outcomes.” You see this all the time in investment literature, especially related to mutual fund performance. Yet, many people still make their investment decisions mostly, or entirely, based on the past performance of the investment. In S&P’s November Persistence Scorecard a few results were cited:

* For the five years ending September 2011, only 9.72% of large-cap funds maintained a top-half ranking over five consecutive one-year periods. The results for mid-caps was only 6.08% of funds, and for small-caps it was only 3.27%. Random expectations would suggest a rate of 6.25%.

* Looking at longer-term performance, 12.23% of large-cap funds with a top-quartile ranking over five years ending 09/2006 maintained a top-quartile ranking over the next five years. For mid-caps it was only 20.22% and for small-caps it was 20.22%. Random expectations would suggest a rate of 25%.

* While top-quartile and top-half rates have been at or below levels one would expect based on chance, there is consistency in the death rate of bottom-quartile funds. Across all market cap categories, bottom-quartile funds have a much higher rate of being merged or liquidated.

The evidence continues to be clear that trying to successfully pick stocks over a long period of time is extremely difficult. There has been some news recently about the retirement of Bill Miller of the Legg Mason Value Trust fund which won Mr. Miller accolades for his 15 straight years of outperformance compared to the S&P 500 index. Unfortunately ,for many investors in his funds, for the five years ending December 31, 2010 his Value Trust fund was dead last among 1,187 US Large Cap funds tracked by Morningstar. Did Mr. Miller lose his touch suddenly? Or maybe, just maybe, his ‘winning’ streak was nothing more than luck. Of all the actively managed mutual funds out there it would seem that someone out there, by chance, is going to have an especially long winning streak. The problem for investors is this: how do you identify who this person is, AND, how do you identify this person in advance of their winning streak? Furthermore, how do you know when to get out before the inevitable losing streak begins? Identifying skill from luck is a daunting task.

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