The Truth About Top-Performing Mutual Fund Managers

by Aaron S. Reynolds

The Truth About Top Performing Mutual Fund Managers Splash image

It’s only natural for investors to look at past performance when selecting managers of either mutual funds or separate accounts. Almost everyone is impressed by a strong track record. However, investors may be making a crucial mistake by fleeing from recent losers and flocking to recent winners, especially if they act on relatively short-term results.

According to a study we conducted at Baird, at some point in their careers, virtually all top-performing money managers underperform their benchmark and their peers, particularly over time periods of three years or less. Rather than abandoning a top-performing manager during one of these periods, investors should anticipate and, quite often, accept this performance cycle. Why? By chasing performance, investors fall into an ongoing pattern of buying after share prices have risen considerably and selling after they have dropped. This behavior opposes the basic tenet of investing—buy low and sell high—and can cut dramatically into investor wealth. In addition, past performance is only part of the story. Professionals who analyze investment managers know that the drivers of performance are equally important.

Our study, which updated and built upon prior research, revealed that investors with the patience to stick with a top manager through trying times are likely to reap greater rewards than those who chase the latest winner. Although there are times when a change in manager is warranted, our research revealed that the longer an investor sticks with a top-performing manager, the better the chances of success.

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Aaron S. Reynolds is a senior portfolio analyst in Baird’s Advisory Services Research at the private equity and wealth management firm Robert W. Baird & Co.
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This article explores the tendency of top managers to underperform and the reaction of investors when they do. It also offers insights to help investors uncover the reasons behind a manager’s performance and make informed decisions based on longer-term results.

Even the Best Investment Managers Underperform

In general, money managers are considered top managers when they have a history of outperforming their benchmarks and their peers. They add real value by producing returns that exceed management fees over a long period of time. Our study looked at a group of more than 1,500 mutual funds with a 10-year track record as of December 31, 2010, and narrowed the list to 600 that outperformed their respective benchmarks by one percentage point or more, on an annualized basis, over the 10-year period. Furthermore, we included only those funds that both outperformed and exhibited less volatility than the market benchmark. This narrowed our list to a select 370 funds. [Editor's note: Aaron Reynolds provided us with a list of the fund names.]

In dollar terms, these top performers generated more than $10,000 in incremental wealth above the benchmark’s return for every $100,000 invested over the period. The average top manager in the study beat the benchmark by nearly three percentage points annualized, net of fees, adding $34,000+ in incremental wealth.

Clearly, this is no ordinary subset of managers. Their 10-year performance records are truly outstanding. One of the purposes of this study was to determine what percentage of these managers fell short of their benchmark over any three-year period within the 10 years (see Note 1 in the box on page 27). The results are compelling. Despite their impressive long-term performance, almost all of these top-performing managers underperformed their style benchmark at some point. In fact, evidence confirms that it is virtually certain that all top-performing managers will go through prolonged periods where they underperform their benchmarks and lag their peers.

Source: Morningstar; Baird analysis.

As Figure 1 illustrates, approximately 85% of the top managers had at least one three-year period in which they underperformed their style benchmark by one percentage point or more. In fact, on average, they underperformed during six separate rolling three-year periods (out of a total of 29). About half of them lagged their benchmarks by three percentage points (on average, three separate times) and one-quarter of them fell five or more percentage points below the benchmark for at least one three-year period.

When compared with their peers, 81% of them fell to below-average in at least one three-year period—and they remained below par for an average of almost four quarters. It appears that when the top managers fall below their peer group median, they tend to remain there for some time.

Depending on which of the three-year periods investors looked at, they could have been highly alarmed by what they saw. Still, all of these managers were top performers over the full 10-year time span.

We also looked at shorter holding periods of 12 months because, in our experience, many investors make decisions based on very short-term performance. The results were even more telling, as shown in Figure 2. All of the top managers dropped below their peer group average at least once. Compared to their peers, there were many 12-month time periods when these top managers disappointed investors.

Moreover, one-quarter of them went through at least one 12-month period where they underperformed their benchmark by 15 percentage points or more.

Clearly, both the frequency and magnitude of underperformance become more dramatic over shorter evaluation periods. Investors who focus on very short-term results may be more susceptible to making imprudent investment decisions.

By these measures, it looks as though all great money managers will go through periods of underperformance. What should investors do when they find themselves in the midst of one of these tough periods?

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Shortsighted Investors Leave Wealth on the Table

Most money managers and mutual funds report performance results over one-year, three-year, five-year and 10-year periods, as well as since inception. However, in our opinion, many investors take action based on the first or second number, and begin a pattern of chasing short-term performance.

As a proxy for gauging investor behavior, we looked at money flows into and out of funds following changes in Morningstar’s star ratings, which are based on past performance relative to peers. The star rating ranks funds based on relative performance within their category over the trailing three-, five- and 10-year periods, adjusted for risk and sales charges (see Note 2 in the box on page 27). As a result, a fund with a strong 10-year record could be downgraded if its three-year performance fell well short of its peer group.

We isolated any period over the past 10 years when a high-performing fund was given a rating upgrade or downgrade and then measured the subsequent asset flows for the following 12 months. When top-performing funds in our study were upgraded from three to four stars or four to five stars, net money flows over the following 12 months were sharply positive—to the tune of $14 million and $331 million, respectively, on average per fund. Similarly, flows were decidedly negative following a top-fund downgrade from three stars to two stars or from two stars to one star (by approximately $65 million and $257 million, respectively, on average per fund).

This shows that investors tend to race into funds after a period of strong performance. As a result, they appear to be buying high (as funds are coming off a strong period) and selling low (as funds are coming off a weak period). This pattern of behavior is in clear violation of the cardinal rule of successful investing: buy low and sell high.

Source: Morningstar; Baird analysis.

So begins the path toward a less-than-optimal outcome for investors. As Figure 3 illustrates, investors who bought a top fund after it was upgraded would have indeed fared well. Over the three years following a rating change from three to four stars or four to five stars, these funds produced an excess return of 1.4 and 1.7 percentage points over the peer average, respectively. However, the downgraded top-performing funds performed even better, gaining 2.0 and 2.1 percentage points of excess return for a rating change from three to two stars or two to one star, respectively.

This research reveals that most high-performing managers can and do make up lost ground and add excess return following periods of weakness, particularly over an intermediate-term time period. By abandoning these managers and failing to exercise patience, investors can leave significant wealth on the table.

Source: Morningstar; Baird analysis. For the 10-year period ending 12/31/2010.

Why a Long-Term Perspective Is Important

Rather than leaving a top-performing manager during difficult times, the evidence suggests it pays to be patient, as shown in Figure 4. Indeed, the longer an investor can wait the better, as managers’ chances of beating their benchmarks increase with longer holding periods. For example, when we looked at performance over the shortest time period, one quarter, the top-performing funds in our study outperformed their benchmark just more than half of the time. However, by extending the holding period to five years, the managers were able to add value almost 75% of the time. Over seven-year holding periods, more than 80% of them beat their benchmarks (see Note 3 in the box on page 27).

This research confirms that fluctuations in relative returns are fairly common over shorter time periods, while outperformance is achieved more often over longer periods. Again, it is critical to avoid making judgments based on short-term performance and to evaluate money managers over periods of time that are long enough for them to prove their worth.

Does It Ever Pay to Make a Manager Change?

Manager performance can lag for a number of reasons. Sometimes the underperformance is expected and is no cause for alarm. Other times there may be signs of deeper problems. Identifying potential red flags means doing homework on money managers—understanding how managers have historically added value and discovering the cause of the underperformance. For example, what are the managers buying? How do they invest? Is the underperformance within the range of expected variation? Here are some considerations:

1. Manager Style

It’s unfair to paint all managers in the same asset class with the same brush. For example, deep value managers look for stocks selling at discounts to their historical valuations, while relative value managers look for stocks that are cheap relative to their prospective growth rates. Likewise, traditional growth managers may have an advantage over managers who adhere to the “growth at a reasonable price” investment style, which tends to be more conservative. In both of these cases, the managers may be benchmarking to the same indexes, but showing very different relative performance results.

2. Market Environment

In our view, investors should always expect some of the money managers within their portfolios to be performing well and some to be underperforming, particularly in very turbulent market environments. Consider the late 1990s, when money managers’ opinions of technology stocks largely determined their relative performance. If an investor retained only those managers who were outperforming, they would have been left with an extremely attractive portfolio, as defined by recent performance. However, their portfolios would also have been quite poorly positioned for the next couple of years.

In turbulent markets, it is especially important to avoid the herd mentality, which can implicitly result in a bet on just one side of the market. Currently, sector and asset class leadership is rotating quickly. A diversity of opinion might achieve a better balance.

3. Asset Allocation

Disciplined asset allocation has been shown to add significantly to investor returns. Investors who approach manager selection the way they approach asset class allocation would rebalance away from recent strong performers and toward recent weak ones. Thus, if they choose to stay with a manager after a period of weakness, they might be able to add wealth by allocating additional funds toward that manager. If they decide to change managers after a period of weakness, investors should recognize they are selling a potentially undervalued portfolio.

When a Change May Be Warranted

All that said, while much of this study highlights the benefits of being patient with underperforming investment managers, complacency is not always the best course of action. There are times when a change is warranted. For example, are the weak results sustained and evident across investment environments? Was outperformance expected given market conditions? These could signal that the manager has made several poor judgment calls in the portfolio. Also, a manager change may be prudent if there have been unexpected qualitative changes, including:

  • the departure of a key manager,
  • a new subadvisor,
  • a change in the investment process,
  • a change in firm ownership, and
  • significant shifts in assets under management.

In Summary

It’s probably smart to stick with top managers who are underperforming, if they are investing consistently within their style and process, even if it happens to be out of favor. Likewise, it is understandable if managers fall short because they are underweighted in one or two stocks or sectors compared with their benchmark. Evaluating managers over a full market cycle can offer deeper insight into the story behind the numbers. Unless the weak results are sustained and widespread, or supported by material changes in the management team or process at the firm, patience is likely to pay off.

A Lesson in Patience

The Baird study and others before it offer an important lesson for investors: Virtually all top-performing investment managers underperform their benchmarks and their peers sometimes—and when they do, it is usually for a relatively prolonged period. Investors who focus on these short-term results may lose out on the incremental wealth that top managers are likely to add in subsequent years. By extending their focus to long-term performance, investors may reap the rewards of their patience.

Investors will always be influenced by a manager’s past performance. But by holding managers accountable for their body of work over time, rather than their short-term results, investors have a better chance of witnessing a top manager’s true potential and building greater long-term wealth.

Note 1

For this analysis, we took a “snapshot” of each fund’s three-year relative performance calculated every quarter, much like an investor would experience when receiving a quarterly statement. This resulted in more than 10,000 observations (29 periods × 370 funds = 10,730 observations). The mutual funds were analyzed relative to their style-specific benchmarks; for example, large growth funds were analyzed relative to the Russell 1000 Growth index. We analyzed funds at the asset class level (i.e., large-cap, mid-cap, small-cap and international) and aggregated the data for presentation.

Note 2

Mutual Fund Style Universe: Style-specific universe of mutual funds as categorized by Morningstar. The Morningstar-generated categories are created by incorporating all the funds in the respective Morningstar categories that have at least 12 months of reported performance. The number of funds included in each category as of December 31, 2010, are 472 for large growth, 596 for large core, 334 for large value, 231 for mid growth, 162 for mid core, 121 for mid value, 228 for small growth, 217 for small core, 105 for small value and 399 for international.

High-Performing Mutual Fund Study: Style-specific universe of mutual funds as categorized by Morningstar, which are created by incorporating all the funds in the respective Morningstar categories that have at least 12 months of reported performance. As of December 31, 2010, according to Baird’s study, the number of funds with a 10-year track record and the number outperforming by 1% or more and having a lower standard deviation are: 166/82 for large growth, 249/50 for large core, 142/32 for large value, 84/53 for mid growth, 80/9 for mid core, 80/6 for mid value, 83/53 for small growth, 90/41 for small core, 48/17 for small value and 187/26 for international.

Morningstar Ratings: The overall Morningstar rating for a fund is derived from a weighted average of the performance figures associated with a fund’s three-, five- and 10-year (if applicable) Morningstar Rating metrics.

For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating based on a Morningstar risk-adjusted return measure that accounts for variation in a fund’s monthly performance (including the effects of sales charges, loads and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive five stars, the next 22.5% receive four stars, the next 35% receive three stars, the next 22.5% receive two stars and the bottom 10% receive one star. Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.

Note 3

For the past 10 years ending December 31, 2010, we tracked the relative performance of each high-performing manager over various rolling time periods. For example, there are 40 one-quarter periods over the past 10 years (40 periods × 700 funds = 28,000 total observations). We recorded how often these managers outperformed or underperformed their respective benchmark over that time period. This same methodology was used to evaluate the managers over one-, three-, five-, seven- and 10-year periods.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. This and other information is found in the prospectus. Please read the prospectus carefully before investing. Past performance is no guarantee of future results.

Aaron S. Reynolds is a senior portfolio analyst in Baird’s Advisory Services Research at the private equity and wealth management firm Robert W. Baird & Co.


Larry from MN posted over 5 years ago:


Alfred from NC posted over 5 years ago:

One might wish to use the balanced mutual fund PRPFX as a reference when evaluating the short and long term performance of mutual funds. It has been a steady performer for over a decade, And for ETFs it is hard tob

Alfred from NC posted over 5 years ago:

An ETF that has been a steady performer over both the short and long term in GLD. I use it as a reference for compareson of other ETFs.

Daniel from AL posted over 5 years ago:

Excellent article. Confirms what many of us have learned the hard way over the years, ie, simply "chasing the stars" is not the smart way to invest.

Louise from WA posted over 5 years ago:

What a stunning result! If you select the top performing mutual funds over the last ten year period, even though they may have several years of under performance, they still end up being the top performing funds. Remarkable. The issue is, what will they do the next ten years, and the answer is, nobody knows. Selecting funds for the future from the rear view mirror is a fools game. Index, index, index.

Frank from CA posted over 5 years ago:

I am with Larry from Minnesota. Where is a list of say the three top-performing managers in each category? That would be great to know and do some research on, such as, what is the ratings given by Forbes and other financially oriented magazines.

Bill from MA posted over 5 years ago:

Whoah, anyone with the brains and sitzfleisch to read this journal and Yahoo Finance (etc.) has the ability to outperform the best managers. I've been tracking my own results vs. several good mutual funds over the past decade. Personally, much better results both short and long term (15%+ per annum), than Fidelity et al.

This is not rocket science, people. My advice, fire your mutual fund company, and buy a few individual bonds some promising stocks. Stop paying somebody to make your investments for you, and reap the rewards of your own decisions.

James from PA posted over 5 years ago:

This is an interesting article and does draw attention to some good general principles that savvy investors should always keep in mind such as 'be patient', 'invest long term', 'don't chase short term results' among them. I've heard all of that so many times I don't need to hear them again. But this article, like so much of the money management commentary on investing strategy, fails to escape the vested interests of the author (A. S.Reynolds), his title(senior portfolio analyst) and position(in Baird's Advisory Services Research) with his sponsor and primary audience(Robert W. Baird & Co. Wealth Management Co.). He is just making a living. After all of those influences are extracted there isn't much left that has any real meaning... It is pablum to draw in new customers and, thank you very much but I don't have tome to waste reading more advertising published under the guise of 'good investing insights'. If the author and his sponsor was courageous he would publish the study results in full - all of the raw data. Then he would go beyond the generalities and give his reader some real insights that are useable without getting a degree in finance. I'm surprised that AAII is still publishing items of this questionable quality.

David from CA posted over 5 years ago:

Simply a fund manager saying he/she outperforms stated benchmark is not enough. We have to take closer look at the fund's investment "style"; if the manager claims they are outperforming S&P 500, analyze their portfolio risk profile. For example, if the manager runs the fund like a hedge-fund, of course he's gonna outperform S&P. What value-add does he offer? I can just goto Vanguard and buy the index ETF myself, much cheaper.

Jim from MI posted over 5 years ago:

Interesting in that even the best have periods of underperformance. But hard to tell what if anything actionable comes out of this, since the study sample chosen (superior 10 year performance) more or less guarantees that you'd regret having dumped their funds. It doesn't tell you anything useful about when you should dump a manager, nor whether a procedure such as looking for inferior 3 year performance to change managers gets you better or worse performance in a replacement manager. As a trivial example, what is the forward-going performance after a downgrade for all managers?

John from BC posted over 5 years ago:

Most if not all of the findings of this article can be explained by random variations in funds returns, without any proof of skilled top performing funds managers. Will the lucky managers from the past 10 years be lucky again in the next 10 years? The 370 funds selected had an average annual return of 3%. Lets look at their performance after a downgrade: If they under-performed for three years, say by -2%, they must on average have a return of 5% for the other 7 years to make the average 3% over 10 years. No wonder they do on average better in the next 3 years out of these 7 years, after a downgrade. Similar arguments can be made for the other statistics in the article. This requires no investing skills; it is based on self-fulfilling after-the-fact statistics.

Rick from VA posted over 4 years ago:

I read the comments first and was happily surprised at how many people get it - that beating the market consistently is tough and finding an investor that can consistently do it is even tougher, so be happy with an index fund that over time and after expenses will beat the vast majority of the actively managed funds. The sucessful long term active investor might in fact just be lucky and one of the normal distribution outliers. This all assumes we are talking about investing in efficient markets.

Rudiger from FL posted over 4 years ago:

I find the study to general and not particularly useful for me. Give me some real examples, i.e. Talk about Bill Miller, Ken Heebner, Bruce Berkowitz and other fallen stars and what the odds are for them to come back.

Phil from NY posted over 2 years ago:

The more I study investing, the more I have evolved to picking my own equities. However, owning some mutual funds and ETFs is still a good idea for core holdings with at least one index fund to mollify any volatility in individual stocks.

Lou H from IL posted over 2 years ago:

Where can we find the top managers in the various categories and what their funds are?

Charles Rotblut from IL posted over 2 years ago:


Our annual mutual fund guide, shows year-by-year performance for mutual funds. Returns ranking in the top 25% of their categories are bolded.

The forthcoming March 2014 Journal will review the funds with the best five-year performance.


Chris Carter from CA posted 3 months ago:

Hmmmm . . . Amusing but not a terribly useful article. As part of my MBA curriculum at U of Chicago, we were taught that fund manager performance over periods less than 20 years is not significant. Random/"lucky guesses" can dominate an abnormal rate of return (beta) over shorter intervals. Of course, not that many managers stick around for 20+ years . . . .probably because the overwhelming majority can't outperform a matched benchmark index. Looking at active manager performance over a 10 year interval doesn't help much . . . unless you have a crystal ball and know which chunks of the 20 you should stay vested and which chunks the manager will underperform. Classic example is the "star manager" ,Bill Miller, and Legg Mason Value Trust. He beat the SP500 every year for over a decade; however, his 15 and 20 years return are well below . . . and he just resigned.

William Parker from AL posted about 1 month ago:

Perhaps investing in the benchmarks with indexing will be advantageous for many. The returns will be higher for most longer periods of time. Taxes are deferred with the accumulation of unrealized capital gains that can be taken as desired.

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