If you didn't already have enough reason to be skeptical of actively managed mutual funds, here's some more ammunition. According to a recent study, active fund managers' past performance is rarely predictive of future returns. And while that little disclaimer is touted on practically every fund's website or prospectus, it's quite another to see how these trends actually play out in the real world.
The sad truth
Advisor Perspectives, an e-newsletter for financial advisors, looked at random funds with a particular Morningstar star rating and compared their performance with randomly selected funds with a lower star rating from the third quarter of 2006 through the third quarter of 2009. The study showed that lower-rated funds frequently outperformed higher-rated ones and that Morningstar's star rating system did not provide a whole lot of predictive value.
This is a problem for investors since so many of them choose funds based on star ratings or past performance. Given that a hot streak of performance may in fact make it more likely that a fund will underperform in the future, active fund investors may actually be hurting themselves by relying on this measure.
I do take some issue with the time frame used in this study. A three-year period is not long-term by any means, and that's primarily what investors should be concerned with. The results may have been different choosing alternate starting and ending points or a longer period of time. However, I can't quibble with the overall results of the study too much. I think they're absolutely right that in many cases, past performance isn't a reliable indicator of future results, and that most active fund managers cannot consistently beat the market. It's sad, but true -- the average investor will underperform the market by investing in the vast majority of actively managed funds.
A silver lining
Clearly, actively managed mutual funds aren't worth anyone's time, right? Well, not so fast. Sure, they may not be for everyone. If you're a diehard believer in market efficiency and don't want to pay someone else to manage your money, inexpensive index funds or exchange-traded funds are the way to go. Just make sure you stick to broad-based, well-diversified options like SPDRs
But while I can't deny that the vast majority of actively managed funds aren't worthy of your dollar, there is evidence that a minority of fund managers DO possess above-average stock-picking skill and DO consistently beat the market. In fact, a Morgan Stanley
Today's losers, tomorrow's winners
Ironically, the same Morgan Stanley study showed that the worst 20% of performers were also likely to outperform in the future. And on a short-term basis at least, that makes sense, if you consider the whole "buy low, sell high" approach to investing. Various sectors and asset classes can run hot and cold and come into and out of favor with investors. As an area of the market becomes depressed, that typically means greater upside once the market cycle changes. It's the ultimate contrarian play -- and you can apply it to your portfolio right now.
Consider what has done the best in the current market rally -- lower-quality stocks and beaten-down names like financials Wells Fargo
But if you want to move beyond individual stock picking and take advantage of the best investment minds in the business, you should be itching to find out just who is in that secretive top-tier of fund managers that consistently outperform. If that's you, you should check out the Fool's Rule Your Retirement investment service. With your free 30-day trial, you'll not only get access to the latest in personal financial planning advice, but you'll also get our list of the top mutual funds in the business -- those champs most likely to beat the market on a regular basis. We rely on much more than just recent past performance to identify winners, so you know you're getting the real deal, not just another flash in the pan.
There are a lot of loser funds out there, that's for sure. And active management will be a money-losing deal for most investors as they continue to chase performance. But if you are lucky enough to find one of those rare gems that actually makes money and beats the market year after year, you'll be miles ahead of the rest of the herd and that much closer to meeting your long-term investment goals.
Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement newsletter. At the time of publication, she did not own any of the companies mentioned herein. Wal-Mart Stores is a Motley Fool Inside Value selection. Johnson & Johnson is a Motley Fool Income Investor selection. Motley Fool Options has recommended a buy calls position on Johnson & Johnson. The Fool owns shares of SPDRs.. Click here to find out more about the Fool's disclosure policy.