The Harm in Selecting Funds that Have Recently Outperformed

Abstract

We empirically investigate the investment results of commonly used fund selection strategies that involve redeploying assets from underperforming to outperforming funds. Based on portfolios constructed using U.S. mutual fund data over typical three-year evaluation periods, we find that investors who chose funds with poor recent performance earned higher excess returns than those who chose funds with superior recent performance. Our findings pose a challenge for asset owners: If past performance is used at all in selecting funds, it is the best-performing funds that should be replaced. Realistically, however, a policy of replacing successful funds with poor performers is unlikely to gain widespread acceptance. Instead, the practical implication of our paper is that asset owners should focus on factors other than past performance. We offer alternate criteria for selecting funds.