By Jyoti Madhusoodanan
A few years ago, James Choi, a professor of finance at Yale SOM, was leading a session for finance executives on choosing fund managers when he realized that one of the foundational studies on which his talk relied was decades old. Since that study, published in 1997 by Mark M. Carhart, the U.S. has been through recessions, wars, and technological and financial innovation. Choi began to wonder whether the advice was still relevant.
Carhart’s classic analysis, titled “On Persistence in Mutual Fund Performance,” called into question the standard disclaimer that past performance is not indicative of future results, concluding that a fund’s performance in the past year does in fact help predict how the fund will fare in the year ahead. But in their new analysis, Choi and Yale SOM finance doctoral student Kevin Zhao found that that there is no longer such a correlation—and that the phenomenon Carhart described was already starting to fade during the time of his study.
Choi and Zhao replicated Carhart’s analysis of mutual funds from 1963 through 1993, and then extended the same analysis to the present day. They found that from 1994 to 2018, a fund’s performance is completely unpredictive of its returns in the future. Even in the period that Carhart examined, a statistically significant correlation was only seen in the years before 1980.
“If anything, over the past two decades, you seem to do a little bit worse if you chase past returns on mutual funds,” Choi says. “For the last 40 years, the Carhart persistence phenomenon hasn’t existed, but nobody had examined whether the Carhart findings are relevant for our investment choices today.”
Choi and Zhao began by revisiting the period that Carhart studied. They found that during the period 1962-93, mutual funds whose past-year return was in the top 10% yielded significantly higher returns in the subsequent year than funds whose past-year return was in the bottom 10%.
But when they looked closer, they found that this effect was greatest in the 1962-1980 period, and tapered off in the later years. Choi and Zhao then extended the same analysis to the years 1994-2018. Here, they found that there was no statistically significant future return difference between the mutual funds with the best performance over the past year and the mutual funds with the worst performance in the past year.
Why have these changes occurred? Choi says that the performance persistence documented by Carhart is commonly understood to arise not because of differences in fund manager skill, but because of a phenomenon known as “momentum”—individual stocks that yielded high returns in the past year tend to do well in the next year. Funds that have been lucky enough to do well in the past year tend to have more high-momentum stocks in their portfolio, so their future returns benefit from momentum. But momentum in individual stocks has weakened in recent years. “Even if you happened to be holding high-momentum stocks in your portfolio, that didn’t give you as much of a return going forward as it used to,” he says. And high-performing funds hold less of their portfolios in high-momentum stocks. “It’s a situation where funds aren’t doing as much of a good thing as they used to, and the good thing isn’t as helpful as it used to be,” he adds.
The results provide an argument for investing in passive mutual funds, which still hold a minority of the money in the stock market, rather than active ones. When trying to find a good fund manager, people look at the funds’ past returns—and those may not be a reliable indicator, Choi points out. “There has been a big debate about whether it’s better to put all your money into passive funds, or if it’s actually smart to do some active management,” he explains. “Our study adds weight to the idea of choosing a passive strategy rather than an active fund that’s trying to beat the market.”
The results also emphasize the importance of continuing to question and critically re-analyze classic studies, Choi adds. “Financial markets and economies aren’t like physics, where in any kind of human scale of time, the laws and phenomena are all the same,” he says. “People and societies change, and markets change, so it’s important to periodically re-check facts that we presume to be true. There’s no law that says they have to be true forever.”