The Persistence of Risk-Adjusted Mutual Fund Performance

A mutual fund is a professionally managed pool of equities owned by its investors. Adjusting mutual fund performances for risk -- using a mathematical comparison of funds with different degrees of risk -- allows investors to fairly compare the price performances of volatile funds with funds that have less price volatility. Volatility and risk are correlated: A fund with higher risk may outperform a fund with lower risk in one period but underperform in another. The persistence of risk-adjusted mutual fund performance interests economic theorists and individual investors, the latter because superior returns are possible if above-average performance persists.

Hot Hands Theory

"Hot hands theory" proposes that some investors are inherently better than others and can outperform the market consistently and over fairly long periods. When investors buy actively managed mutual funds, they do so in the belief that some fund managers can produce persistently better-than-average results. They're willing to pay higher management expenses and fees than those associated with passively managed funds that try to match the performance of an index like the S&P 500.

Efficient Market Theory

"Efficient market theory" contradicts "hot hands theory" in proposing that, at any given time, all relevant information about an equity is incorporated in its present value; an efficient market takes into account the totality of market information and accurately represents it in the current stock price. If this theory is right, investors over the long run achieve better results buying funds with the lowest management expenses and fees, because no mutual fund persistently produces better price performance than another.

The Most Influential Study

A 1987 study published in "The Journal of Finance" by Mark M. Carhart has been cited in more than 6,000 other academic studies, which indicates that its views have been unusually influential. Carhart concludes that fund managers can use momentum strategies to outperform the market in the short term due to a one-year momentum effect based on recent price, earnings, sales and positive cash-flow outperformance; they aren't able to produce better-than-average long-term performance, however. He also concluded that some fund managers do underperform over long periods. Put simply, in the long run, a good fund manager may not help you, but a bad one can hurt you.

Superior Performance May Be Temporary

A 2013 University of North Carolina study led by Jason P. Berkowitz comes to slightly different conclusions but may implicitly explain what Carhart noted -- that bad fund managers persist in underperformance. Berkowitz and his co-writers studied two groups of managers -- one made up of managers with four consecutive quarters of top 10 percent performance and the other made up of managers with four consecutive quarters of bottom 10 percent performance. They observed that both groups were overconfident, took on more risk, diversified less and traded more often than managers with average performances. In time, however, the best managers moved toward the average, trading less, diversifying more and reducing risk. The worst managers, however, persisted in underperforming.

Hot Hands Theory Uncomfirmed

Before Carhart's 1987 study, the validity of "hot hands theory" was inconclusively debated. Since then, the consensus view is that managers might have hot hands over a short period -- from a few months to three years -- but no evidence shows that a manager with purportedly hot hands can persistently beat the market over a longer term.