The financial world constantly debates the relationship between a mutual fund's past performance and its future success. In 1997, Mark Carhart published a seminal paper titled On Persistence in Mutual Fund Performance, which has since become a cornerstone in understanding the phenomenon of performance persistence within the mutual fund industry.
Carhart’s research provided empirical evidence on whether past success in mutual funds was due to skill or luck and challenged many of the assumptions that investors held about performance consistency. Let’s explore the key findings of Carhart’s research, the lessons investors can take from his work, and the implications for mutual fund investing today.
KEY FINDINGS OF THE PAPER
Carhart’s study aimed to answer a critical question: Can mutual funds consistently outperform the market over time or is strong performance largely a matter of luck? Using a dataset of US mutual funds, Carhart examined fund performance across multiple time periods to determine whether persistence was evident.
He introduced what is now known as the Carhart four-factor model, which builds on the Fama-French three-factor model by adding momentum as an additional factor alongside market risk, size and book-to-market value to explain returns.
Limited long-term performance persistence
Carhart found that while some mutual funds showed short-term performance persistence, particularly over one-year periods, this persistence largely disappeared over longer horizons. Funds that performed well in one year were often unable to replicate that success in subsequent years. This suggests that consistent outperformance over extended periods is rare, particularly when controlling for other factors.
The implication is that while short-term success may be driven by specific market conditions, it is not necessarily a reflection of the manager's skill. Longer-term performance is far more challenging to sustain, especially in an efficient market where opportunities for outperformance are limited.
Role of momentum
One of Carhart's most significant contributions was identifying the momentum factor as a key driver of mutual fund returns. Momentum refers to the tendency of stocks that have performed well in the recent past to continue performing well in the short term, and vice versa for underperforming stocks. Carhart showed that much of the persistence observed in mutual funds could be attributed to managers who capitalised on momentum strategies, rather than their inherent ability to pick superior stocks.
This discovery highlighted the fact that momentum, a market anomaly, could inflate short-term performance, but it was not a reliable strategy for long-term outperformance. Once momentum effects were accounted for, the evidence for skill-driven persistence weakened considerably.
Impact of fees on performance
Carhart’s research also shed light on the significant role that fund expenses play in eroding performance. He found that high fees and expenses greatly reduced the chances of long-term outperformance. Even funds that demonstrated strong gross returns often struggled to deliver net returns (after fees) that beat the market over time.
This finding underlines the importance of paying attention to a fund's fee structure. Investors often overlook the compounding impact of fees, which can detract from overall returns, particularly in actively managed funds that charge higher fees. As Carhart’s study suggests, choosing funds with lower fees may increase the likelihood of seeing better long-term performance.
Survivorship bias
Carhart addressed the issue of survivorship bias in mutual fund performance studies. Many performance datasets exclude funds that have been closed or merged due to poor performance. This can distort the perception of persistence, as only the successful funds remain in the sample, leading to an overestimation of the likelihood that funds will continue to outperform.
By accounting for survivorship bias in his analysis, Carhart provided a more accurate picture of performance persistence, showing that many funds that initially perform well do not sustain their success over time.
LESSONS FOR INVESTORS
The findings from On Persistence in Mutual Fund Performance offer several key lessons for investors seeking to navigate the complex world of mutual fund investing.
- Don’t rely solely on past performance
One of the clearest takeaways from Carhart's work is that past performance, particularly in the short term, is not a reliable indicator of future success. Investors should be cautious about choosing funds based purely on historical returns. While a track record of strong performance may seem appealing, it is often driven by temporary market factors rather than a manager's skill.
Instead, investors should focus on understanding the underlying strategy and whether it is repeatable across various market environments. Funds that rely heavily on momentum or short-term trends may struggle to sustain performance when market conditions change.
- Consider fees carefully
Carhart’s research underscored the importance of fund expenses in evaluating long-term performance. High fees can significantly erode returns over time, making it difficult for even the best-performing funds to consistently beat the market after costs are accounted for.
Investors should weigh the cost of active management against the likelihood of achieving outperformance. In many cases, lower-cost options, such as index funds or ETFs, may offer a better risk-return profile over the long term.
- Be aware of survivorship bias
Carhart’s study reminds investors to be mindful of survivorship bias when reviewing fund performance data. Just because a fund has been successful doesn’t mean it will continue to exist in the future. Many underperforming funds are closed or merged, leaving only the stronger funds in performance datasets.
Investors should seek out data that includes both surviving and non-surviving funds to get a clearer picture of the true odds of performance persistence.
- Diversification is key
Another important takeaway from Carhart’s research is the need for diversification. Momentum strategies may work in certain market conditions, but they are not a guarantee of long-term success. Diversified portfolios, which spread investments across asset classes and strategies, are less vulnerable to market anomalies like momentum.
A diversified approach can help protect against the risks of overreliance on one factor or strategy, making it a more robust option for long-term investors.
IMPLICATIONS FOR TODAY'S INVESTORS
Carhart’s findings remain relevant today, especially in a market environment where passive investing and low-cost funds have gained popularity. While some actively managed funds can outperform in the short term, the long-term evidence suggests that few are able to consistently beat the market, particularly after fees.
For investors looking to achieve long-term growth, focusing on low-cost funds, being mindful of fees and avoiding the temptation to chase past performance are sound strategies. Furthermore, Carhart's identification of the momentum factor provides a reminder that not all outperformance is the result of skill and that market anomalies can skew short-term results.
On Persistence in Mutual Fund Performance remains a foundational text in the field of investment research. It highlights the challenges of relying on past performance as a predictor of future success and provides a roadmap for understanding the limitations of mutual fund returns.
For investors, the key lessons from the paper are clear: be cautious of chasing past returns, pay close attention to fees, diversify your investments and recognise that long-term success requires a disciplined, strategic approach. While mutual funds may show persistence in the short term, the road to consistent long-term outperformance is far more uncertain.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.