Practical analysis for investment professionals
03 September 2018

Chasing Mutual Fund Performance: Follow the Momentum?

Chasing mutual fund performance suffers from a bad reputation these days. Of course, perspectives change all the time in finance. What was once considered poor form often becomes best practice and vice versa.

Leveraged buyouts and activist investors, for instance, were once looked downs on by much of the sector, but today their milder incarnations are staples of pension fund portfolios and are perceived as forces of good, not evil.

So maybe investing in the best-performing mutual funds isn’t a bad strategy. It is certainly a popular one.

The question is, how does mutual fund momentum chasing play out in the US market?

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Chasing Momentum

To answer that, we looked at US equity mutual funds from 2000 to 2018 and created long-only portfolios composed of the top and bottom 10% of funds. We then replicated classic equity momentum strategies, selecting mutual funds based on their performance over the previous 12-months and rebalancing the portfolio on a monthly basis.

We found the best-performing funds beat an equal-weight index of all equity mutual funds as well as the worst-performing funds by a handsome margin. Put another way: Performance chasing works.

Momentum in Mutual Funds

Momentum in Mutual Funds

Source: FactorResearch

Of course, most mutual fund investors won’t be willing to rebalance their portfolios every month. Moreover, our calculations did not include transaction costs, which are likely in excess of 1%. As a consequence, these results are more theoretical than practical.

And, if we impose a minimum holding period of one year, performance chasing looks far less appealing. The best- and worst-performing funds with one-year holding periods generated similar returns from 2000 to 2018, albeit with significant differences in performance at different times.

Momentum in Mutual Funds: Different Holding Patterns

Momentum in Mutual Funds: Different Holding Patterns

Source: FactorResearch

Classic Mutual Fund Selection

Although buying winners and selling losers in equities is typically based on a 12-month lookback period, such a time frame is rather short for most mutual fund allocators. Since investors seek to distinguish the skilled managers from the lucky, they usually analyze fund manager performance over several years.

Three years is considered the bare minimum for evaluating mutual funds, which hopefully includes some ups and downs in stock markets. Applying this momentum strategy, we selected funds based on their three-year performance and held them for one and three years, respectively.

The results suggest that mutual fund chasing deserves its bad reputation. The worst-performing funds outperformed the best-performing, regardless of the holding period. This indicates that mean-reversion, not momentum, dominates fund returns when measuring funds on longer-term performance.

Momentum in Mutual Funds: Three-Year Performance

Momentum in Mutual Funds: Three-Year Performance

Source: FactorResearch

That said, when the analysis begins has a significant influence on the outcome. For example, the worst-performing funds generated the best returns between 2000 and 2002, but fell back to earth thereafter. Why the initial outperformance? The implosion of the dot-com bubble: The worst-performing funds probably held far fewer technology stocks than their counterparts.

The same calculus applies to the global financial crisis in 2008 and 2009: The drawdowns of the best-performing funds are significantly higher than those of the worst performers, presumably because the latter had less exposure to the sectors — banks and real estate, for example — that underperformed during the crisis.

These results suggest the best-performing funds lose more during crashes, giving up all the outperformance they achieved in the stable years. Therefore, past performance does not seem meaningful for selecting funds for a full market cycle.

Risk Metric Comparison

So do the worst funds yield less attractive risk-adjusted returns than their better-performing peers. We found the dismal performers generated higher risk-return ratios than the standout funds in all scenarios except for one: when momentum is measured with a 12-month lookback and one-month holding period. And that scenario would likely be different were trading costs factored in.

Momentum in Mutual Funds: Risk-Return Ratios, 2000–2018

Momentum in Mutual Funds: Risk-Return Ratios, 2000–2018

Source: FactorResearch

Further Thoughts

So does performance chasing in the mutual fund universe deserve its less-than-stellar reputation? It depends. If the momentum strategy is systematically implemented, frequently rebalanced, and has low transaction costs, it can generate excess returns.

But as a rule, performance chasing is best avoided. Our analysis indicates that investors would be better off betting on mean-reversion.

For more insights from Nicolas Rabener and the Factor Research team, sign up for their email newsletter.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ IwanRmp

About the Author(s)
Nicolas Rabener

Nicolas Rabener is the managing director of Finominal, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focused on real estate across asset classes. He started his career working for Citigroup in investment banking in London and New York. Rabener holds an MS in management from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

8 thoughts on “Chasing Mutual Fund Performance: Follow the Momentum?”

  1. abhi says:

    Good article..

  2. ettore trucco says:

    It would be interesting to see the results with 1 month holding period and 12m momentum, but only if 12m momentum is positive (sort of trend following…)

  3. Robert says:

    Interesting research Nick! Mutual funds are a bad starting point but definitely have some unique trading patterns. Momentum works until it doesn’t… mean reversion is a better bet as you mention.

  4. Ananthi Mathur says:

    Hi, You have really explained well about Mutual funds and this will surely help the new investor as well as people who are interested to invest in mutual funds.

  5. Bhagath Varma says:

    Investing in mutual funds is a very popular option among people of all ages. Experts often suggest that it performance chasing and understanding mutual fund performance in terms of momentum is problematic and it is actually the mean reversion that dominates mutual fund performance. Past performance cannot be used as an indicator of better returns as one often finds that it is the best performing funds that lose more in crashed.

    However, if you are a beginner, these terms can be daunting, so you can track your mutual fund performance by comparing your fund returns with the corresponding index benchmarks (say Sensex, NIFTY, BSE Small Cap, etc). Some of the platforms that help you in tracking the mutual fund performance include Money Control, Value Research Online, etc. Recently, it has become an industry practice for AMC companies to offer their clients an online portal where they can track the performance of their invested mutual funds.

  6. GWC says:

    Since Momentum investing performs very well in rising markets, it complements well with Value Investment style that may lag behind market in good times. This provides good diversification to value investment style. Once again, momentum investing doesn’t perform in every short period.

  7. Small Investors says:

    Everyone in the US markets is certain that the recession is coming from Blankfein to Bernanke to even Musk. (What is recession: 2 consecutive quarter of economic decline or GDP fall is called recession). Do you remember US GDP declined 1.4% last quarter already – but no one cared so much.

  8. Ipshita Ghoshal says:

    Mutual Fund performance is affected by the decisions that the fund management team takes, as well as twists and turns in the market, either equity or debt. Typically, all fund management teams have a process in place that dictates the choice of securities in the portfolio.
    Since Momentum putting performs very well in rising business sectors, it supplements well with the Value Investment style that might linger behind the market in great times. This gives great expansion to esteem speculation style. Yet again force putting doesn’t act in each brief period.

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