The Question Every Investor Asks
Before allocating capital to an active fund, investors invariably look at its track record. This behaviour is almost universal — retail investors, financial advisers, and sophisticated institutions all give significant weight to past returns. The implicit assumption is that a manager who has outperformed in the past is more likely to outperform in the future. The research literature has systematically tested this assumption and, with near-unanimous results, rejected it.
Carhart's 1997 Study
Mark Carhart's landmark paper "On Persistence in Mutual Fund Performance," published in the Journal of Finance in 1997, is the most cited study on this question. Carhart examined a comprehensive dataset of US mutual funds from 1962 to 1993 and asked: after controlling for the momentum factor (which could mechanically create apparent persistence by rewarding funds that happened to hold last year's winning stocks), is there evidence of genuine alpha persistence?
The answer was essentially no. After removing the momentum effect, there was virtually no evidence of persistent alpha in mutual fund performance beyond one year. Top-quartile funds in one period were no more likely to be in the top quartile in the following period than chance would predict. The only meaningful persistence Carhart found was negative: poor performers were somewhat more likely to keep underperforming — largely because high expense ratios are a persistent and reliable drag on net returns.
Earlier Evidence: Gruber's Puzzle
Martin Gruber's 1996 paper "Another Puzzle: The Growth in Actively Managed Mutual Funds" asked a related question: if active funds underperform on average, why do investors continue to use them? He dubbed this the "smart money" hypothesis — perhaps some sophisticated investors can identify skilled managers. His evidence for this was weak at the time and has not strengthened since. The puzzle he identified — rational investor behaviour in the face of poor expected outcomes — remains a live question in behavioural finance.
The Intuitive Appeal and Its Failure
The intuitive appeal of past performance is understandable. In most fields, demonstrated competence predicts future competence. A surgeon with a strong track record, a lawyer who wins cases, an engineer who builds reliable structures — past performance is informative. Investment management appears similar on the surface. But there are critical differences: the signal-to-noise ratio in investment returns is extremely low, the time periods required to distinguish skill from luck are decades long (not years), and the competitive environment changes continuously.
A fund manager who outperformed over five years may have benefited from a style tailwind (value was in favour, or growth was in favour), sector concentration (technology in the 1990s, energy in the 2000s), or pure statistical luck. Distinguishing genuine alpha — consistent outperformance across different market environments — from these noise sources requires far more data than is typically available.
The Reversion Problem
Investors who chase past performance also face mean reversion. Funds that have recently outperformed often attract large inflows of new capital. This capital must be deployed into the market — often into the same positions that drove the outperformance. As more capital chases a strategy, it can erode the very source of the excess return. The investor who enters a top-performing fund after its strong run is buying at the peak of its tailwind, precisely when reversion to the mean is most likely.