No doubt you’re familiar with the phrase ‘past performance is not a guide to future performance’. Although we see this every time we invest in a fund, it’s still all too easy for investors to fall into the habit of paying too much attention to past performance metrics. These might include a fund’s performance over one, three or five years in relation to its benchmark, or its performance compared with other funds in its sector.
The problem with past performance
There are inherent issues with using this quantitative measure all on its own, and it depends on when you look. Each period of analysis could have its own quirks, which can either make a bad fund look good or a good fund look bad.
“If past performance has any predictive value we should expect the funds that generate a good three-year performance to the end of one year go on to do well in the next,” says Jason Broomer, head of investment at Square Mile Investment Consulting & Research.
Square Mile looked at large-cap and multi-cap funds in the Investment Association (IA) UK All Companies sector and ranked them according to their three-year performance between 2013 and 2015, and analysed the correlation between the funds’ previous three-year performance and subsequent performance in 2016.
“The complete randomness of the result is striking," says Mr Broomer. 2016 was a particularly difficult year for UK equity funds given the resurgence in mining stocks in February and the EU referendum in June. Any fund not exposed to miners or international earners severely underperformed the index, and sector exposure rather than stockpicking talent drove returns. However, Mr Broomer says the results apply over almost all time periods.
He says: "We can extend this analysis across different periods and different sectors, it makes little difference to the results. This is why we believe that building a fund selection process relying on raw performance data is unlikely to be successful over the long term.”
Although generally investors recognise the truth of this statement, they often turn to performance figures as a means of narrowing down the 3,000-plus options. You might decide to screen funds by focusing on the ones that have performed best over five years, for example.
“But once you do so you’ve already biased your sample by searching for performance,” says Ainsley To, research analyst at wealth manager Credo Wealth. “[All performance screens] have embedded within them the assumption that past performance can tell you something about future returns.”
And unlike with stocks – where buying shares that are performing well has been shown to lead to greater returns – funds do not seem to display the same momentum effect.
“When you’re investing in a stock and it does badly it’s very hard to sell it as you’re admitting a mistake and taking the loss [and this behavioural pattern is what causes the momentum effect],” says Mr To. “But the behavioural research suggests for funds, because investors are delegating the stockpicking to a manager, they are more likely to sell because they are firing a manager.”
Size and style
There are other reasons why focusing solely on a fund’s past performance can be an unreliable method, such as a manager change during the period you are looking at. The old manager may have produced very good results, but has since left, and therefore the performance delivered cannot be attributed to the current manager.
Cumulative figures such as a fund’s performance over one, three, five and even 10 years, can also be misleading, particularly if you are unaware of any significant market gyrations that happened over the period. The year 2016 is a case in point, when the mining sector and sterling devaluation were the biggest drivers of markets, not fund manager talent, so it could flatter or hamper performance figures over the long term.
“A fund could have had brilliant five-year performance, but once you drill down you could find they’ve had a very lucky six-month period, which has skewed the figures,” says Jason Hollands, managing director at Tilney Group.
Investors should also pay attention to the potential impact a fund’s size has on its ability to deliver future returns, he adds.
“Funds that have had very good performance when they were a tiny size (of up to £100m) and have subsequently grown may not be able to use the same process that delivered that performance, so their returns may not be replicable in the future,” Mr Hollands says. “Maybe the fund previously invested heavily in small-caps, but now it has to have more in big blue-chips for liquidity’s sake. Or maybe it had to increase its portfolio from 30 to 60 holdings, thus diluting performance, because it had to find more assets [to put their increased cash to work].”
Past performance also does not account for investment style. A fund manager could be very good, but if their way of investing is out of favour with the market then performance can be affected. This has been the case with value investing, which focuses on buying undervalued companies, and has languished against growth investing for the past decade. As a result, many value funds are currently at the bottom of performance tables. But this does not mean they will stay there.
Beyond performance
Looking at a fund’s past performance gives investors useful information about how a fund has behaved in previous market conditions, so it is still worthwhile factoring into your decision-making process. But don’t expect past performance to tell you how a fund will perform in future. Mr Broomer therefore recommends that investors also use other methods to choose active funds. See below for some suggestions from Mr Broomer on how else you can pick a fund, other than relying solely on its past performance metrics.
Hannah Goldsmith, founder of independent financial adviser Goldsmith Financial Solutions, often uses tracker funds for client portfolios as she thinks the lower costs of investing passively are beneficial for future returns. “Financial services can be a major drag on investors’ future wealth,” she says.
Investors should consider the total cost of their investments, including the underlying fees of their funds as well as any platform and adviser fees, she says. Due to compounding, even a small difference can have a big impact over time. The lang cat, a consultancy, has calculated that £100,000 invested over 30 years, growing at an average of 6 per cent a year, would total £432,194 if total fees equalled 1 per cent. But with total fees of 2 per cent this would only grow to £324,340.
Mr To suggests investors pick funds based on the type of investment style, or factor, they want exposure to, such as value or growth.
“When we are picking funds we are looking for ideas that we like and we see the manager as the person who is going to implement that idea for us,” he says. “If you think cheap stocks beat expensive stocks, go for funds that implement that view in the most consistent way and try to pay as little as possible. By focusing on funds with systematic approaches you don’t have to worry about the manager getting out of bed and changing the process.”
Good active managers have a role to play but investors should be prepared to work to really understand how a fund works, good active managers are useful says Mr Broomer. “There are some managers you can identify who have a terrific long-term track record and do seem to have had success at outperforming the market consistently, not every year but more years than not,” he says.
In order to separate the wheat from the chaff you should focus more on the individual manager’s track record, rather than the fund’s record. And you should also understand the manager’s investment approach and in what market conditions their style is likely to work or not work by researching the fund thoroughly.
Information on individual track records can be hard to find, but Tilney Group has a database of individual fund manager career track records, you can see this by clicking on a fund using Bestinvest’s website.
This shows how an individual manager has performed over their entire career in a particular sector across multiple employers. It includes the average monthly return a manager has delivered relative to the sector benchmark and the percentage of months the manager has been up or down against the market.
Its Manager Record Index (MRI) statistic measures the likelihood the fund manager is adding value through their decisions, rather than just being lucky.
Examples of managers Mr Hollands likes and who have high MRI scores are Nick Train, who runs LF Lindsell Train UK Equity Fund (GB00BJFLM156) and Anthony Cross and Julian Fosh, who run Liontrust Special Situations Fund (GB00B57H4F11), an IC Top 100 fund. Mr Train has an MRI score of 83 per cent, while the Liontrust team have an MRI of 99 per cent.
Mr Broomer also picks out Mr Train as well as Terry Smith, who runs IC Top 100 fund Fundsmith Equity (GB00B41YBW71). And he believes Ben Whitmore, the manager of Jupiter UK Special Situations (GB00B4KL9F89), and Kevin Murphy and Nick Kirrage, the managers of Schroder Recovery Fund (GB00BDD2F190), are also good managers, despite their value style being out of favour.
