One of the most frequent behaviors in 401-K plans is for participants to move their money to the fund choices that did best in the past year. It is a good use of common sense — to think that the fund that did better has a smarter manager and is a better place for making money in the future than a manager whose fund did poorly last year.

Unfortunately, research does not back up this concept. S&P (Standard and Poors) keeps a scorecard that tracks whether or not outperforming funds continue their success over time. This month, they released their updated findings. Their research tracks funds across several time frames, various fund types, and also filters funds by top quarter and top half. The basic idea is that if fund managers’ good performance is due to their skill rather than luck, it will continue over time. Sadly, the research they do almost uniformly shows that this is not the case. For instance, of the funds that were in the top quarter of US stocks for a one-year period in September of 2013, only 4.28% remained in the top quarter in September of 2015. Far from persisting, there is some indication in these numbers that they do worse than you would expect by pure chance. There are some areas where managers seem to operate a bit better, such as emerging market bonds and multi- cap funds (that is, funds where the manager can decide whether to buy small, medium, or large size companies and can move amongst the areas according to their discretion).

Many would take this as a sign to always choose a passive index over an actively managed fund. At Capstone, we don’t think that is necessarily the best conclusion to draw from the data. We do think that expenses make it difficult for managers to outperform indexes over time, especially in large and transparent indexes. So, it makes sense that a great manager can show his mettle more frequently in thinly-traded emerging market bonds than in the S&P 500 Index. We think it also makes sense that managers can perform a bit better in a multi-cap fund, as they are able to use their skills more if they aren’t constrained in terms of what they can buy and sell.

We also think a healthy mix of passive indexes and skilled managers remains the best way to capture gains and regulate risks. Looking at who performed well last year delivers results that are largely due to chance. Looking under the hood of a fund at the philosophy, process used, culture of the people involved (e.g. is your manager putting your interests above his or hers, do they have skin in the game by investing in the fund themselves, etc.), and the performance of the fund can give you accurate long-term results.

Simply looking at how funds performed last year is why all fund literature reminds you that “past performance does not necessarily predict future results”. Research says much the opposite.

By Ted Schwartz, CFP®