An additional test of the predictive value of historical performance was conducted by investment consulting firm DiMeo Schneider. Its analysis identified funds in various investment categories that had been in the top quartile over the past 10 years — funds that many investors would be drawn to. The study concluded nearly 85% of those top-quartile funds (across all categories) delivered investment results below their respective benchmarks for at least one three-year period (12 consecutive quarters) during that same 10-year period.
"The Morningstar Ratings Methodology" document states, “While the long-term overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.” Based on this, there should be a concern that funds which have performed well in the most recent three-year period will have a higher rating and will lead investors to the conclusion that these funds will outperform going forward.
A discussion of the current environment might shed light on the risk of chasing recent outperformers. It is commonly believed that high-quality stocks act as a cushion during market downturns, thereby providing downside protection. If this thesis is correct, then one would expect that in periods of declining risk, narrowing credit spreads and flattening yield curves, the quality premium would tend to be negative and managers who invest in the stocks of high-quality companies would underperform.
This has proved true during the recent market recovery. From January 1, 2009, and March 31, 2011, those stocks with higher variability in growth and stability of earnings and dividends have dramatically outperformed the stocks of higher quality companies.
The ratings of many low-quality, high-beta focused mutual funds have increased dramatically based on their short-term outperformance during this timeframe. But as markets refocus on the quality of earnings, we would expect these managers to underperform, disappointing investors who have relied on their recently improved ratings.