It is a phrase that appears on just about every advertisement in the asset management industry that promotes a fund. But even though any investment expert will say “past performance is no guide to the future”, it is hard to ignore the past in the absence of other ways to illustrate a fund manager’s abilities.
Whether by force of habit or simply conviction, investors tend to rely on historic data to guide their decisions, potentially to their detriment. It is not hard to understand why investors would rely on past performance; advertising in the fund management industry is awash with bold statements about how one fund is better than others because of its superior performance record. All too often it is only in the fine print that readers are warned of the dangers of making a decision based entirely on this fact.
Academics at Arizona State University found the presence of such a warning from the US Securities and Exchange Commission that past performance is no guide to the future had no preventative effect; investors were just as likely to allocate to a fund with good past performance whether it was there or not.
Additionally, there is crowd mentality when markets are performing well. Investors tend to follow the herd when it comes to investing because of the sense of safety they feel it provides. But in their quest not to miss out on potential gains, many of them end up losing because their decisions came too late.
It is often said that 80 per cent of fund managers fail to beat their benchmarks, while 20 per cent are incapable of outperformance on an ongoing basis. Yet in many cases the investor is attracted by a stellar run of performance, even if it is impossible to sustain. But is there a valid argument for looking at past performance when making an investment? While experts say it should not be relied upon as a be all and end all metric, there are certain situations where it can be effective.
Benefits of hindsight
Research compiled by Standard Poor’s in its Persistence Scorecard from December 2012 shows how unlikely it is for a fund to perform well year after year. The survey of 707 US mutual funds found that, of those ranked in the top quartile in September 2010, just 10 per cent were still in the top quartile two years later.
Furthermore, during the three years to the end of September 2012, SP found just 23.6 per cent of large-cap funds, 15.5 per cent of mid-cap funds and 29.4 per cent of small-cap funds were able to keep a top-half ranking throughout three consecutive 12-month periods.
Armed with perfect hindsight, the hard facts prove the vast majority of funds are unable to maintain high performance for the long term. While a tiny minority have been observed to be successful year in, year out, most of the market is in fact a bit of a disappointment.
A quick example of this for UK funds can be seen in Chart 1. Of the 355 funds that were top-quartile in their own sectors in 2008 – with quartile ranking based on the previous five years’ performance – only 76 of them, around 20 per cent, were top-quartile five years later in 2013. In fact, 89 ended up bottom quartile and 19 were liquidated.