Young & Invested: The illusion of ETF returns
Finding false comfort in recent winners overlooks an important signal of fund quality.
Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.
This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.
Edition 44
The end of the year is upon us, and so is the inevitable roundup of the best and worst performing ETFs. If you’re wallowing in self-pity about the missed market opportunities that were so obvious, feel free to join the club. If only I had a crystal ball into the seemingly thriving uranium market.
Performance lists make for easy headlines and quick talking points for fund providers. They can also make investors feel considerably worse about achieving otherwise unobjectionable returns. I admit I often scan over them, analysing my portfolio returns in retrospect. But they shouldn’t be mistaken as a shopping list for a viable investment strategy going forward.
Extrapolating past performance leaves us in danger of recency bias aka the tendency to believe that what just happened will continue to happen. In this case, it’s picking investments assuming that the recent winners will keep winning.
Fund marketing can reinforce this by spotlighting absolute or relative returns. There’s rarely any indication of whether a manager or strategy can continue to deliver consistently over time. That doesn’t mean these rankings are entirely arbitrary. The real question isn’t who won this year, but whether they’re able to do it again. Persistence is one of the most important characteristics for long-term investors.
Academics have long contemplated whether it’s possible to reliably identify the funds that will keep outperforming. In theory, persistent outperformance shouldn’t last forever. Superior returns often attract new inflows that push a fund toward capacity limits, or managers raise fees, both of which erode its edge. More fundamentally, performance tends to revert to the mean. This describes the phenomenon of a fund that beats its peers in one period being statistically more likely to settle back toward its category average over time.
In reality markets are imperfect, meaning that persistence can vary across asset classes, fund characteristics and market conditions. The real value of looking at persistence is not to find the next star fund but to understand where consistent performance is likely and the areas where underperformance sticks.
Morningstar’s recently released Fund Persistence Study examined how likely a top-performing mutual fund or ETF was to maintain its standing within its category and what circumstances influenced the result. The analysis covered nearly 9,000 funds representing about $24 trillion in assets which is roughly two thirds of the U.S. fund market as of mid 2025.
What persistence means for investors
In simple terms, persistence is about consistency. In the context of this study, it measures the probability that a fund will stay in the same performance bracket (quartile in this context) over time. These rankings are calculated relative to all funds in each Morningstar category, including active, passive and strategic beta funds which are commonly referred to as a ‘passive outlier’.
But why does this matter? Long-term portfolios are built with the purpose of compounding steadily, rather than constantly rotating in and out of funds. Frequent turnover in your portfolio can trigger transaction costs, capital gains tax, and unnecessary churn. In an ideal world, we want funds to demonstrate persistence within higher quartiles.
Amid all the noise of annual fund performance rankings, looking at persistence helps separate luck from genuine skill. Those that can consistently remain in the highest return quartile point to a manager’s skill or some type of structural advantage. If there is a lack of persistence, returns are more likely to be luck.
Passive or Active
One way to study persistence is to identify top performing funds within a category and test if they remained a top performer over subsequent years.
Exhibit 1 below shows how many actively managed mutual funds and ETFs ranked in the top performance quartile of their category in 2021 and stayed there over the subsequent three years. Long story short, persistence was fleeting across all categories.
By 2022, only a few funds remained in the top quartile. And in over half the categories, not a single fund managed to stay at the top for three years through 2024. Notably, some categories did slightly better e.g. core bond funds but even then, only around 17% still resided in the top quartile by 2024.
The pattern also persists in passive funds. It’s tempting to believe that passive funds are safer when it comes to staying on top of performance tables. But this study found that passive and strategic beta funds are no more likely than actively managed funds to remain in the top quartile of their category year after year. In other words, staying passive doesn’t guarantee persistence.
In many categories, the outcome was worse for passively managed funds compared to their actively managed counterparts. Many failed to crack the top quartile in 2022, let alone persist over three years. The main exceptions were in the large blend and large growth categories. The short-term performance of index funds tends to be tied to how their segment performs since they’re intended to mirror the market.
It’s worth noting that passive is often used as shorthand for broad-market index funds (e.g. an ETF that tracks the S&P 500), however the category in this study encompasses a wide range of strategies. Many niche strategies like sector and thematic ETFs are technically passive because they track an index, however their persistence can vary. Looking at these under one umbrella risks oversimplifying ‘passive’ investments.
Rotating into whichever asset class or niche index happened to outperform last year is unlikely to deliver consistent results. A broad-market index tracker will continue to mirror its benchmark, but persistence across narrower passive strategies is far less reliable. The gameboard below highlights the annual returns for select asset classes ranked in order of performance each year. We can observe that the winners shift around unpredictably, emphasising the randomness of trying to chase past performance.
Source: Vanguard Asset Class Tool.
The persistence of weak performance
Anyone somewhat familiar with the investing world has heard the all too familiar warning “past performance is not necessarily indicative of future results”. And for good reason.
When we look at fund performance over longer horizons (three and five years), evidence shows that the top quartile of active funds don’t show much persistence aka they rarely remain at the top of their game. This points to their chances of repeating that strong performance as random. This is why it’s important not to get caught up chasing recent winners.
Although, the story somewhat diverges for the bottom-quartile performers.We found that weaker funds tend to stay weak and the longer they underperform,the more likely they are to either remain in the bottom-quartile or disappear through mergers or liquidations. Exhibit 8 shows that across five years,more than half of the bottom-quartile funds either remained at the bottomor shut down.
In other words, strong past performance and ‘best performing funds lists’ aren’t helpful, nor do they reliably predict future success. But for funds that performed poorly, the probability of them continuing to do so, being liquidated or merged increases substantially with time. I’ve previously written about whether you should sell underperforming ETFs here.
The role of volatility
Interestingly, the study found that persistence among actively managed mutual funds and ETFs may be more attainable when markets are stable and move in a consistent direction.
Exhibit 9 compares the probability of a fund remaining in the top quartile for two consecutive years with the VIX Index (a common measure of market volatility). The data shows that during quieter periods like 2016-2019 when the VIX was low, top quartile persistence often exceeded 30%. In contrast, as volatility spiked in 2020, this dropped to around 15%, its lowest level in five years.
Active managers often argue that theoretically volatility creates opportunity, given market swings result in fundamental price divergences. Whilst the findings of this study don’t seek to refute that idea, they do show that managers fail to exploit this consistently.
Perhaps the volatility equals opportunity assertion is overly simplistic. It certainly magnifies dispersion, but it also magnifies luck. The persistence data shows that sustained outperformance is rare and turbulent market conditions make it increasingly difficult to stay in the top-quartile of performance.
Concluding thoughts
We tend to consider our asset allocation decisions in retrospect. Every December investors mull over ‘best funds’ lists, lamenting about products that have outperformed their portfolio tenfold.
But the reality is you will always find an asset class or product that outperforms your portfolio. These winners rarely retain their position, with persistent outperformance particularly difficult during times of increased volatility.
As the time horizon increases beyond five years, past performance becomes less important in determining a fund’s category-relative performance. Beyond that, low fees, a sound investment process, solid managers and a fund’s category are key. As always, the real edge long-term investors can exploit is the ability to keep fees low and spot behavioural traps from afar.
You can access the full study here.
