There are many variables that investors analyze when either buying or selling assets. One popular technique used to analyze stock mutual funds and exchange-traded funds (ETFs) includes analyzing past performance and using this information as the catalyst to either buy or sell. Generally, investors tend to buy funds that have recently had a strong performance and sell funds that have recently experienced poor performance. At first glance, this technique intuitively makes sense. However, a more in-depth look will illustrate how this may not always work as intended.
To understand the dangers associated with using past performance to drive your investment decisions, it is important to understand some basics surrounding mutual funds and ETFs. A few common classifications for stock funds include U.S. vs. international, large vs. small, and growth vs. value. For simplicity, this article will focus on U.S. stocks that are either growth- or value-oriented.
There is no one definition of what constitutes a growth stock versus a value stock. Generally, growth stocks are thought to have greater future growth potential. In contrast, value stocks are thought to be below their fair market value, making them favorably priced relative to what they are actually worth. A common ratio used to classify growth and value stocks is called the price-to-book ratio, which is calculated by dividing a stock’s price by its book value per share. Generally, stocks that have higher price-to-book ratios are classified as growth stocks, while stocks with lower price-to-book ratios are classified as value stocks.
Nobel laureate Eugene Fama and distinguished professor of finance at Dartmouth College Kenneth French have conducted significant historical research on both growth and value stocks. Part of their research has included tracking the performance of these two categories through filtering stocks by their price-to-book ratios. This filtering led to the creation of the Fama/French US Value Research Index and the Fama/French US Growth Research Index.
Dimensional Fund Advisors analyzed data since 1928 regarding the 10-year performance of growth versus value stocks using the growth and value indices created by Fama and French. Their analysis showed a few interesting themes:
• Value stocks have outperformed growth stocks in 82.5% of the 10-year time frames.
• Growth stocks have been outperforming value stocks over recent 10-year time frames.
• Historically, when growth stocks have outperformed value stocks over 10-year time frames, they have underperformed value stocks by a large margin in the following 10 years.
Since 1928, there have been 14 10-year time horizons where growth stocks have outperformed value stocks. Of these 14, there are six that have subsequent 10-year time horizons and eight that do not. This could be attributed to the fact that these time horizons happened in the recent past, and not enough time has passed yet for them to cover a full 10 years. Among the six time horizons with subsequent 10-year time horizons, value stocks have averaged 8.49% better per year in the subsequent 10 years when compared with growth stocks. Additionally, there have never been two consecutive 10-year time frames where growth stocks have outperformed value stocks.
The historical performance of growth versus value stocks is significant for multiple reasons. First, growth stocks have been outperforming value stocks in the most recent 10-year time horizons, which could ultimately lead to future underperformance if history repeats itself. Second, if investors are choosing to purchase mutual funds based on past performance, it’s important to understand the root reason for the historically strong performance. If the root cause of strong past performance can be attributed to a large percentage of the fund being allocated to growth stocks and it still holds a large percentage in growth stocks, this could cause underperformance of the fund if history repeats itself. Finally, there is a growing movement of investors and advisors shifting money into index funds and ETFs. Many of these funds have a larger percentage in growth stocks when compared with value stocks due to the rules on how they are managed.
Understanding the relationship between performance and category allocation is important when selecting funds. This relationship is also important to analyze when constructing a portfolio of several funds. If proper balance is not maintained within your portfolio, you could be unintentionally increasing risk, while also reducing future returns. This article focuses on growth stocks, and due to the strong performance of this category in recent years, this problem will likely rear its head once again in the future.