Is history a fair guide to investing?

Most advertising material related to funds carries the obligatory disclaimer: "past performance is not a guide to future performance". It's a legal requirement but how accurate is it? The fund industry certainly doesn't seem to believe it's true.

A 2013 study by Todd Schlanger and Christopher Philips for passive investment group Vanguard showed that funds which had lagged both the market and their peers were more likely to be shut down or merged than others. Technically speaking, if past performance is no guide, there is no reason to close underachievers more often than winners.

But we also know that even funds run by respected investors suffer periods of poor performance. For example, Bill Miller's Legg Mason Capital Management Value Trust beat the market for 15 years in a row from 1991 to 2005, but underperformed for five out of the six following years. Warren Buffett's Berkshire Hathaway has had a spectacular 50-year run, but has failed to beat the market since the financial crisis.

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So what does the data say? Charles River Associates looked at fund performance between 1981 and 2001 for the Investment Association, and found evidence of "persistence" in fund returns. In short, investors buying funds in the top quartile of annual performance would have done much better than those buying funds in the bottom quartile.

A recent Standard & Poor's study found that 28.9% of the 678 US equity funds that were in the top quartile in 2013 remained in the same position in 2014. Since you would expect 25% to remain in the top quartile by chance, this points to some persistence. But how long does it last? The jury's still out.

Mark Grinblatt from UCLA found evidence of persistence for up to five years, looking at performance between 1974 and 1984. However, a recent study by Alex Bryan and James Li of Morningstar, which analysed several past studies, concluded that beyond a few quarters "there is no meaningful relationship between past and future fund performance". Why might that be? We look at one idea below.

Funds that are hampered by success

The classic example of a successful fund that has been forced to alter its style of investing is Berkshire Hathaway, which currently has a market cap of more than $360bn. This has forced Warren Buffett away from investing in mainly small-cap shares, towards buying large chunks of blue-chip stocks, or even entire companies.

It has also forced Buffett to take stakes in stocks that he is less enthusiastic about, turning Berkshire into a "closet tracker" fund. As early as 1999 he complained that he could get much better annual returns if he only had $1m to invest.

Fans of bigger funds argue that they have several advantagesover smaller ones: economies of scale spread administrativeand research costs over a wider asset base. They also claim toget better access to meetings with company management.

Inmany cases their size can win them a seat on company boards,allowing them to influence strategy directly. Indeed, a 2008study by Ajay Khorana of Georgia Institute of Technology foundthat larger funds tended to have lower fees.

However, overall the weight of evidence seems to favoursmaller funds. A 2004 study by Joseph Chen of the University ofSouthern California found that between 1966 and 1999bigger funds (in terms of asset size) did worse than thosewith fewer assets under management. This outperformancepersisted, even after fees were taken into account.

A study byNick Motson of City University London found this applied tohedge funds too, with smaller funds beating larger rivals. Thiscould go some way to explaining why "persistence" is so low performance tends to attract inflows from newinvestors, which makes a fund bigger and more unwieldy.