From time to time I'll speak with someone who has been so indoctrinated by the industry's mantra that past performance isn't predictive of future performance that they have a hard time believing momentum strategies, like SMI Upgrading, can possibly work. Usually they're polite enough to refrain from calling me a liar when I tell them that there's plenty of research supporting the idea that recent performance is predictive of short-term future performance.

The key terms there, of course, are recent and short-term. The research is equally clear that longer-term past performance — generally defined as anything longer than one year — is not predictive. That's the point that so many have seized upon and beaten into the minds of individual investors.

In fact, recent years have seen a widespread legitimization of the momentum effect in academic circles. A grudging acceptance of the small-company and value approach effects has built over the years. Some still try to explain those away, but many have recognized those two approaches as legitimate market inefficiencies. Momentum has been rapidly gaining as a third widely accepted market inefficiency that can be exploited by investors.

Right before the September issue went to the printer, I came across an article by William Droms, who has authored some papers about performance persistence. We included an excerpt from this article as a MoneyTalk column in the back of the newsletter, but since I know not everyone makes it all the way through every issue, I thought I'd mention it here as well.

It's brief, so I'd encourage you to look at the whole thing. But I wanted to comment on a few specific points.

Past performance counts. The studies generally demonstrate that past performance persists in the short run but there is very little evidence of persistence in the long run. The studies find with remarkable consistency that superior performance in one year is associated with superior performance in the following year, but superior performance generally does not persist to the second and subsequent years. This finding is consistent with the stock momentum effect that has received increasing acceptance in the past few years. In short, hot hands persist, albeit for short time periods.
This is the foundation of our Upgrading strategy, that one can earn superior returns by monitoring performance from within the past year and constantly standing ready to "upgrade" from one fund to another. Call it persistence, momentum, hot hands, or cream cheese...it works.
Within-category performance is more persistent than performance relative to the overall market. Performance persistence is best evaluated relative to a style-based benchmark rather than the market in aggregate.
An interesting observation, given that SMI decided long ago to apply our momentum evaluation process within each distinct "risk category" rather than more broadly (as some others have done). We didn't do it because we thought it would necessarily work better. Instead, SMI did it that way as a nod to the principle of diversification and the idea that it seemed best to always maintain a more broadly diversified portfolio. But it's reassuring to see that the research seems to back our approach as the preferred way to go.
International equity fund persistence is stronger than U.S. fund persistence. The one study specifically testing persistence of international equity funds found highly significant persistence for one-year holding periods, but no evidence of persistence for two-, three- or four-year periods.

Another very interesting point for SMI Upgraders. Our foreign group has consistently shown strong results from the Upgrading process. The category doesn't always look good compared to the U.S. market, but compared to the average foreign fund, SMI's Foreign Upgrading recommendations tend to really excel. (You'll see more evidence of this next month in an article we're working on for October.)

I've always tended to think this was because the pool is the widest within our foreign group — all foreign funds get lumped in together, whether large/small, growth/value. But it could just be that momentum works particularly well with foreign funds.

If you're interested in more of the specific studies and findings on the performance persistence topic, Droms references a 2006 paper he wrote entitled "Hot Hands, Cold Hand, Does Past Performance Predict Future Returns?" It reviewed the major research articles on the subject published in peer-reviewed academic finance journals over the prior 15 years. If you want academic science backing the validity of the Upgrading strategy, that's a good place to start.

In closing, I want to add to the argument I made yesterday in discussing Morningstar's 5-star funds and the fact that their superior performance definitely does NOT persist. In that post, we quoted the fact that only two of 715 top-performing funds stayed in the top 25% over a four-year period. As crazy as that might seem, consider the following from "Does Past Performance Matter? The Persistence Scorecard." It shows how difficult it is for funds just to stay in the top half of their peer groups.

Similarly, only 3.09% of large-cap funds, 3.6% of mid-cap funds and 5.48% of small-cap funds maintained top-half performance over five consecutive 12-month periods. Random expectations would suggest a repeat rate of 6.25%.
This just shows how futile the pursuit of great "all-weather funds" is. Buying specific funds and holding them long-term will inevitably expose you to periods of significant underperformance. Thankfully, the research is confirming what Upgraders have long known: there's a better way to pick funds.