Larry Swedroe

Does Consistency of Investment Style Impact Persistence of Performance?

The Holy Grail of investing is to develop a methodology that enables an individual to identify, in advance, the top-performing mutual funds. Unfortunately, while it is always easy to identify the top performers after the fact (which is what Morningstar and other ratings services do), it has proven extremely difficult, if not impossible, to do so before the fact. With the potential for huge rewards, tremendous resources are dedicated to discovering this Holy Grail.

There have been hundreds of academic studies on the issue of persistence of performance. The evidence from these studies suggests that any persistence is due to exposure to the risk factors of size and value, and a third factor - momentum (a factor that improves the explanatory power of a factor model, but one that cannot be exploited due to the costs of the effort). Thus the evidence suggests that past performance of active managers is not a useful predictor of future performance.

A study, " Staying the Course: The Impact of Investment Style Consistency on Mutual Fund Performance," took a different approach.(1) The authors, Keith C. Brown and W.V. Harlow, acknowledged that a fund's investment style (exposure to risk factors) influences returns generated. However, they sought the answer to a different question: Does the execution of the style decision influence returns? The working hypothesis was that there is a positive relationship between a fund's style consistency and persistence of performance. The logic behind the hypothesis is both simple and sound. It is highly likely that funds that are style consistent are funds with low turnover - various studies have found a negative relationship between turnover and returns. For example, a study by Mark Carhart, "On Persistence in Mutual Fund Performance," concluded that turnover costs approximate one percent of the value of the assets traded. Thus funds with higher turnover have higher hurdles (greater costs) to overcome in order to deliver persistent outperformance.

Carhart also concluded that:

• Once common risk factors (investment style) such as size and value are accounted for, the average active fund underperformed by 1.8% per annum.
• Any persistence in fund performance was easily explained by common factors such as expenses, transaction costs, and exposure to the aforementioned risk factors.
• Expenses have a one-for-one negative impact on performance. The more dollars expended on research and trading, the lower the returns.(2)

Brown and Harlow also hypothesized that "regardless of turnover, managers who commit to a more consistent investment style are less likely to make errors than those that attempt to time the market in terms of investment style." This assumption is also logical in light of Carhart's findings.

The Brown and Harlow study used a survivorship bias-free universe of all mutual funds classified by Morningstar over the period from January 1991 to December 2000. The database included 3,177 funds, including 140 index funds. The following is a summary of the authors' findings:

• Funds that are most consistent in investment style over time repeatedly produce better absolute and relative performance than those that style drift - there is a positive relationship between consistency of style and persistence of performance. Funds with high style consistency outperformed funds with low style consistency by 15.79 to 13.10 percent.
• Funds that are style consistent also have lower portfolio turnover (lower costs). However, even controlling for turnover, funds that are style consistent have better performance.

The authors also found, as did Carhart, a negative correlation between fund expense ratios and returns. They found that funds with low expense ratios outperformed those with high expense ratios by 15.58 percent to 13.44 percent.

Also of interest is that the authors found that large-cap funds demonstrate more style consistency than do small- or mid-cap funds. This finding should not come as a surprise. Because investors believe that past performance is a predictor of future performance, successful small-cap funds tend to attract large cash flows (especially after they receive a top Morningstar rating). The large inflow often forces them to move from a small-cap fund to a mid- or large-cap fund in order to keep trading costs (especially market impact costs) low. This has negative implications for investors using active funds to gain exposure to the small-cap asset class.

Another finding was that funds with stricter adherence to their investment style also tend to have lower expense ratios (explaining their superior performance). While there is no logical explanation for this finding, the authors hypothesize that the "managers who charge higher fees are active investors seeking to obscure their performance by letting their investment style drift."

None of the conclusions should come as a surprise to believers efficient markets. What is surprising is that the authors failed to note that the funds with the lowest expense ratio and perfect style persistence are passive asset class and index funds. Thus they logically have the greatest persistence of performance. Using them as the building blocks of a portfolio is playing the winner's game.

(1) Keith C. Brown and W.V. Harlow, "Staying the Course: The Impact of Investment Style Consistency on Mutual Fund Performance," March 8, 2002.
(2) Mark M. Carhart, "On Persistence in Mutual Fund Performance," doctoral dissertation, University of Chicago, December 1994.

Larry Swedroe is the author of "What Wall Street Doesn't Want You to Know" and "The Only Guide To A Winning Investment Strategy You Will Ever Need." His third book, "Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today," will be published in April 2002 by St. Martins Press. Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.