Even most successful funds will underperform over certain time periods. Most people aren't cut out for this and therefore should use index funds.

The “slow-and-steady” fund manager is a myth and investors hunting for such funds are largely wasting their time, Morningstar analysis has shown. Instead, they should assume that the most successful funds will be erratic and underperform over certain time periods. Most people aren't cut out for this and therefore should use index funds.

Morningstar analysts examined the calendar-year net returns of more than 4,800 unique US stock funds for the 20-year period from 1998 to the end of 2017, including dead funds. We ranked the funds for each calendar year based on their net returns against their category peers. We then tallied up the number of times each fund finished in the top half of performers during the 20-year period.

Of the 4,807 funds we examined, 3,343 survived at least five calendar years. Of those 3,343, a grand total of 15 funds--or 0.5 per cent--managed to land in the top half of their peer group in at least three of every four calendar years. But when you consider that seven of those 15 funds were index funds, the pool of slow-and-steady funds shrinks to almost nothing.

On a longer-term basis, things look even worse: of the 2,158 active US funds which lived at least 10 calendar years, not a single fund landed in the top half of its peer group in at least three quarters of the years.

On average, US stock funds landed in the top half only about 24 per cent of the time, or in roughly one of every four calendar years, irrespective of whether they survived at least five or 10 calendar years.

The conclusion for investors? Top-performing funds routinely underperform, sometimes by a lot.

Funds which ranked in the top 10 per cent of their peer groups over the 10-year period to the end of 2017 obviously performed well. But they were no strangers to the bottom half or even the lowest 25 per cent of their peer groups. These 174 standout active US funds lagged or underperformed in about one of every three calendar years, with 109 of these funds spending at least one year in its peer group's bottom quartile – ie. 75 per cent of a fund’s peers outperformed it over the period.

Underperformance part of fund investing

Rather than chase the dream of the slow-but-steady fund, investors should grapple with the realities of investing in active funds, where underperformance is a feature, not a bug. This demands patience, resolve, and not a little contrarianism.

They should ask themselves whether they have the stomach and nerve to remain with active funds that are anything but slow-and-steady. Can they identify and stick with long-term successful funds which lurch, confound, and frustrate over the short term? Most don't and therefore should choose index funds.

For those investors who have the stomach and steel, they're likely to be best-served by managers who know the true meaning of slow but steady. This is demonstrated by a strong commitment to the investment process, a shareholder-friendly parent company, and competitive fees that give the strategy a fighting chance of succeeding over the long haul.

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Jeffrey Ptak is head of manager research at Morningstar, based in Chicago.

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