Bogle says you shouldn’t use past AGGREGATE returns to pick funds

It’s natural, intuitive and almost seems like a no-brainer to review a fund’s past performance and then pick a fund with the best past track record. This is particularly true for people with a scientific, analytical or numbers bent of mind. I did that myself for many years.

So let’s say I wanted to pick a mid-cap fund. I would go to Valueresearchonine.com, select the mid-cap category of funds and sort them by say their past 10 year returns, and then pick any of the top 3 funds based on past 10 year returns and maybe a few other criteria like fund manager longevity etc.

But Bogle says that’s not the way to pick active mutual funds.

John Bogle was founder of the Vanguard Group, one of the largest investment firms in the world. Vanguard has over 9.3 trillion dollars in assets under management.

Common Sense on Mutual Funds is a book Bogle wrote on investing that has since become a classic for investors worldwide and is a book recommended to most investors by Warren Buffett

On the topic of using a fund’s past performance to pick a mutual fund, Bogle says: “There is no way under the sun to forecast a fund’s future absolute returns based on it’s past record”. Bogle further goes on to say that: “There remains no evidence – none – that superior past performance is predictive of future success”

Bogle, however, goes on to say that 2 things indeed CAN be predicted based on the past performance of a fund:

1. Funds with high expenses will underperform appropriate market indices***

2. Funds that have done much better than the indices will regress toward & usually below the market mean over time

In simple terms, it’s like the law of gravity. What goes up must eventually come down.

Here’s some data from the analysis of US funds: (Data on funds in India over 2 decades has been hard to get so we often get forced to use US fund data for longer periods of time)

I quote from the above ET article: “It is impossible for a fund to remain a top performer across market cycles. Data from FundsIndia shows that only one out of four top performing funds over a three year time frame continued to remain in the top quartile over the next three years. Over five-year time frames, only one out of five funds could manage this feat”

Here’s some more data from the above ET article showing how top ranked funds (based on past 3 year returns) become bottom ranked funds over the next 3 years. For example the top ranked fund based on performance data from 2018 to 2020 became the 190th ranked fund from 2021 to 2023

Arthgyaan has also done an interesting analysis on this for funds in the Indian Mutual History.

For the data below, he assumed that a person invested (and reinvested every year) in the 10 highest performing funds based on the previous 3 years’ performance data.

The middle column in the chart shows returns generated by the top 10 funds of the previous 3 years. The last column on the right shows the returns generated by the top 10 funds of that year itself.

When one decides to be in the game of selecting actively managed mutual funds, there is one more significant problem that crops up.

When one has chosen an actively managed fund, one has decided on a strategy that looks to be invested in one of the best performing funds at all times – if not the top performing one, at least one that is say in the top quartile compared to it’s peers. This inevitably means that to stick to your strategy, you will most likely have to switch from one active fund to another. In the bargain, you will be obliged to pay taxes. These taxes will further lower your returns.

This is why, for those of you investing in active funds, it is extremely important to be able to accurately measure the overall returns that your fund switching is finally giving you. This is not easy when switching funds.

Some years ago, when I used to invest in actively managed mutual funds, I would look at it’s past 3, 5, 7 and 10 year performance in terms of returns generated and select based on that.

I did some due diligence & analysed the 10 year results of the actively managed funds I selected from 2016 onwards. In particular, I looked at how that turned out compared to investing in the corresponding benchmark Index fund over the same 10 year period.

When I did the analysis, 17 out of 25 actively managed funds (i.e. nearly one third of the funds) that I selected based on past performance data gave returns lower than the corresponding benchmark Index. So my personal experience more than validates the data & research above. And this is why I now follow Buffett’s advice to invest in Index funds instead

In summary, US Data that is available over approx.. 40 years shows that hardly any top performing funds of one decade remain in the top quartile in the following decade. The comparatively limited historical data & reports we have on Indian mutual fund performance data shows a very similar trend as the US Data: Over a 3 year period, only 26% of the funds that were in the top quartile remained in the top quartile over the following 3 year period. That number drops to 20% when we look at 5 year performance data. The trend is clear: The longer the investment horizon you have, the less likely it is that any top performing fund will remain a top performer. Of this you can be almost certain.

My own personal experience of buying dozens of actively managed mutual funds in the past confirms this data. From the set of actively managed funds I invested in from 2016 to 2020 (by which time I had already been investing in mutual funds for 15 year) 17 of 25 funds I selected gave returns lower than their corresponding Index. This was what led me to finally realise (after 20 years !) that for me at least selecting actively managed mutual funds is a fools errand. That’s when I finally switched to investing only in Index funds as advised by Buffet.

To conclude, let me once again quote Bogle: “Choosing a fund based on past performance leads you in the wrong direction. Ignore it.”