Fund managers and financial advisers put a lot of emphasis on past performance when they promote funds. Investors often base their investment decisions on the same information. But such an approach is flawed at best, and disastrous at worst.
Investors who pick funds by choosing those at the top of the performance tables are making the basic investment mistake of getting in at the top, when most if not all of the growth potential for a particular sector or area has been realised.
Outperformance rarely lasts long
Even if the approach is more sophisticated, perhaps choosing the top performing fund in an out of favour sector, academic research shows that outperformance, whether of a stock market index or an average of competing funds, rarely persists. Even where it does, there is no way of predicting in advance which funds will achieve it consistently.
Fund providers have taken to promoting fund managers, as much as the funds themselves, on the basis that their performance is a better indicator. Fund managers often move around, so it is more useful to track how they have performed at their various jobs than to check the record of a fund that may have had several managers over the period in question.
But there is no more evidence that fund managers can produce consistently good performance than there is that funds can, or that those who have done well in the past will continue to do so. Or even that the performance record can be attributed to one individual rather than a team.
The cult of the manager
Even so, investors may decide to put their faith in a particular manager. There are a few who appear to have done very well for their investors over long periods. The best known is probably Warren Buffet, the Omaha-based investment guru who runs the American investment vehicle Berkshire Hathaway.
There is no comparable figure in the UK investment industry. The nearest contender is probably Anthony Bolton, who has been looking after investors money at fund manager Fidelity for over 24 years. Even he was distinctly unfashionable for a period in the 1990s when the technology boom was in full swing, and Bolton's value approach to investing was out of favour.
Specialist publisher Citywire (www.citywire.co.uk) and advisory firm Bestinvest (www.bestinvest.co.uk) both publish fund manager performance figures for those persuaded that this is useful information.
Investors looking for a more informed approach to choosing a good investment recognise that the performance record of a fund should come some way down the checklist. Right at the top are the issues of risk and charges.
A fund will only be a good investment if it fits with an investor's aims and requirements, and complements any existing investments.
Rate the risk
Assessing the risk level of a fund is not always straightforward, and there is no standard approach to the risk labelling of funds. It is up to managers how they do it, or whether they do it at all. The Financial Services Authority has not tackled this aspect of fund information either, restricting the information it provides on its website (www.fsa.gov.uk/tables/) on individual savings accounts (Isas) mainly to charges.
One website that does offer risk rating is FT Fund Ratings (http://funds.ft.com/funds), which ranks funds by risk, charges and performance, with five different risk levels.
Volatility and charges
The risk level of a fund is measured by its volatility, or the tendency of a fund to rise and fall rapidly and unpredictably in price. FT Fund Ratings categorises funds with an average weekly change in their price of up to 8 per cent as very low risk, while those that move by more than 27 per cent are very high risk. The former category is restricted to money market and bond funds. The latter includes technology funds and US small cap funds, for example.
Charges are also an important element in fund choice. A fund with high charges will have to grow faster than one with lower charges to provide the same return. So it makes sense to choose low cost funds wherever possible.
