Over the 10 years ended May 31, 2025, do you know what separated the leading and lagging active large-blend funds? It was 1.6% per year, which is the difference between the return of the funds at the 25th percentile (12.1%) and the 75th percentile (10.5%) over that period. That’s not nothing, but it’s a pretty slim margin.
Now, how much would you guess separated the leading and lagging active large-blend fund over the 12 months ended May 31, 2025? 4.3%. OK, how about the year ended May 31, 2024? 6.7%. What about the year ended May 31, 2023? 3.5%. Here are the return differences for all 10 one-year segments that made up the 10 years ended May 31, 2025.
In the average year, the leading fund topped the laggard by more than 5 percentage points, which is more than triple the outperformance margin over the full decade.
This isn’t a quirk of large-blend funds. It’s widespread. To illustrate, this scatterplot compares the 10-year annual return differential of the leading and lagging active fund in each category (the horizontal axis) to the average differential in the 10 one-year segments that made up that decade (the vertical). It didn’t matter what type of fund it was; in a typical year, the leader topped the laggard by a much larger margin than the leading fund surpassed the laggard over the full decade ended May 31, 2025.
So, you might be asking yourself: How could there be such wide performance differences over short periods but much narrower margins as you elongate the period you’re measuring? It’s not like these shorter periods don’t make up that longer period, after all.
Luck (and Life) Runs Out
The biggest reason is mean reversion. Some funds will race ahead over the short run, maybe thanks to an advantageous style tilt or luck that broke their way. For others, it will be just the opposite. But as time goes on, the short-term leader’s performance might slip because its luck ran out or the stylistic winds shifted, and vice versa for the laggard. These amplitudes can offset, pushing returns toward the norm and narrowing return spread.
(I’ve done some research examining persistence of performance, and it does appear that, in recent years, past performance has done a better job of forecasting future returns. But that study looked at the relationship between funds’ past and future 60-month returns, whereas this looks at the relationship between returns in a single year versus a 10-year span.)
A second factor is fund mortality. Funds come and go, and those that are merged or liquidated away are almost always mothballed after they underperform, whereas the victors live on. This has the effect of removing a portion of the return distribution—that is, the records of the laggards that have been shut down—narrowing it in the process.
Low Stakes?
This holds a few lessons.
First, choosing an active fund isn’t as low stakes as the narrow difference between the return of the leading and lagging fund over a 10-year period might suggest. Why? While it might not seem like you’re forgoing much upside if you end up with a laggard, that assumes you’re choosing a fund every decade or so and letting the chips fall where they may. That’s not how the world works, though.
For one thing, investors don’t typically wait that long. Though they’ve gotten much better about sticking with their investments, it’s still not uncommon to see them anchor on a shorter interval, like three years. That puts investors on a shorter decision cycle, and over those shorter spans, the difference between outperformer and underperformer can be more significant, as we’ve seen. The more decisions, the more those differences can compound.
And even if we were to suppose the investors are the stick-with-it types, there’s still the matter of funds dying in droves. Indeed, only about one half of active funds in existence have had a lifespan of at least 10 years. Here is a breakdown of active funds by lifespan.
When funds die, it truncates the investor’s holding period, no matter their intentions or resolve. That, in turn, opens the possibility that there could be a large gap between their fund’s performance and others that survived (and presumably fared much better) over that truncated period they owned it.
If the consequences of choosing the wrong active fund are potentially bigger than it might appear at first blush, then isn’t that just further justification to index and call it a day? It is.
Next Up: Private Funds
It’s said that manager selection is crucial when it comes to private funds. Why? The reason most often cited is the very large gap between the returns of the best and worst private equity and venture funds. I have some thoughts, but we’ll save that for a follow-up article that will serve as a companion to this one. Keep an eye out!
Switched On
Here are other things I’m writing, reading, listening to, or watching:
- “We Are Automatic”: A synopsis of Vanguard’s “How America Saves” study
- “Yield Magicians”? Jason Zweig on why single-stock call-writing strategies are a rotten deal for investors
- The drought ends: SSGA’s private credit exchange-traded fund finally saw an inflow (via Outer Beach Conor)
- Would you trade liquidity for an extra 50 basis points or so a year in return (before fees)? BlackRock is about to put that question to the test
- Travel teams needs to chill: “Confessions of a Very Mediocre Youth Sports Parent”
- The creative process with Stephen Merchant, who co-created the original British version of “The Office”
- Horsegirl “Phonetics On and On”
Don’t Be a Stranger
I love hearing from you. Have some feedback? An angle for an article? Email me at jeffrey.ptak@morningstar.com. If you’re so inclined, you can also follow me on Twitter/X at @syouth1, and I do some odds-and-ends writing on a Substack called Basis Pointing.