Predicting Past Performance

Picking investments based on past performance is a lot like driving while looking only in the rearview. Photo by Manuel Montero/Getty Images.

How do you decide? In investing, this is a critical question, potentially, the dividing line between successful investing and serial failure. Knowing where to put your money is a challenge, and there are no shortages of guides, opinions and press speculation over where to put your hard-earned savings. Many rely on industry ratings—pick the three- or four-star fund and call it a day. Or they hire some “professional” who runs a similar analysis. Can’t miss, right? Problem is, ratings and “top fund” rankings overweight past performance. Seem rational? Here’s the catch: selecting a fund based on past return generally fails to find one with good future returns.

A simple truth: past performance doesn’t guarantee or even allude to future returns. Every fund prospectus and disclosure says this. But too many investors unwittingly invest as if the opposite is true, basing decisions on past performance. Many brokers and IFAs are guilty here, too. On both sides of the Atlantic, investment professionals claim to “manage the (fund) managers” and end up allocating more of their clients’ money to strategies that did well in a given year and punishing those managers who fell short.

Aside from the fact hot funds are fleeting, this introduces several pitfalls. If you’re counting on them to “manage the managers”, this implies you are paying them to police fund managers and fire ones that don’t do well, so that they can show they are doing something in their job as middlemen. If you’re paying them to be a watchdog, they have an incentive to continually turn over funds and concentrate in what just did best—not necessarily what’s likely to do best looking forward.

Fund leadership, too, is almost always short lived. Most high-flying funds become laggards within a year or two later. A semi-annual study by S&P Dow Jones Indices LLC consistently finds almost all top-quartile US mutual funds quickly fall from grace. For example, 692 funds were in the top quartile in September 2011; 7.23%, or 50 funds, were still there two years later.

To know whether a top fund has a high chance of staying that way, you have to understand what drove that top-flight performance. Was it is due to one or more outsized bets that happened to play out that year? If so, was it skill or luck? You can’t know unless you know the underlying rationale. If it was a well-thought out, rational plan, is that same fund manager still there? The average fund manager’s tenure is only about 4.5 years—turnover is all-too common. Strong short-term returns might also be sheer happenstance—a function of the fund’s particular style, size, sector or country mandate. If the fund’s mandate coincides with whatever was hot, it’ll do great. But that doesn’t mean top performance repeats.

If you or your adviser flock to the funds that just did best, because fund performance is heavily influenced by style mandate, there is a high likelihood you end up over-concentrated in certain categories—under-diversified. It could throw your portfolio out of whack and increase risk where you don’t intend to. Plus, leadership among investment categories changes irregularly—different countries, sectors, sizes and styles take the lead all the time. If you’re in what did well, you might be underexposed to what will do well. That is potentially a huge opportunity cost.

In my view, there are also severe philosophical flaws with a “manage the managers” approach. If you engage an adviser, you probably want someone to recommend and manage a portfolio strategy designed to reach your long-term goals over your entire investment time horizon. If you go with “manage the managers,” you’re hiring someone to make the most critical decision—the asset allocation decision, or the proportion of stocks, bonds, cash or other securities. Credible academic research has long stressed the critical importance of this choice. Then they turn around and outsource stock selection to fund managers who don’t know you—don’t know your goals, needs and objectives, and they don’t know how the rest of your money is allocated. Fund managers don’t know how other fund managers are invested either! One might buy a stock while another sells. You might have 10 fund managers all buy the same thing. Or you might have 10 funds with 100 different stocks each. The result is an inefficient and potentially over-diversified product soup. It’s a bit like having an architect outsource construction of one room each to nine different construction companies who aren’t talking to one another and can’t see the overall blueprint. You might get very nice individual rooms, but the whole house is what counts—and that may look very bizarre.

Ask yourself: If an adviser recommends this and doesn’t see the inefficiencies—after they’ve essentially admitted they don’t have the acumen to oversee the entire investment process—what is the likelihood they get that critical asset allocation correct? How qualified and expert can they really be?

So what’s an investor to do? For starters, look for an adviser or manager with a long and verifiable track record and long-tenured decision makers. Recognize that even the best advisers and fund managers are bound to underperform in short periods of time. Perform ample due diligence to ensure that your investment manager’s and your interests are aligned—compensation arrangements are critical. Do your due diligence on the adviser’s values—find out what they believe in, why they’re in business, what their ethical standards are and how that meshes with your own beliefs. Discover how they’ll employ their values, beliefs and expertise to your benefit. Learn everything you can about their investment process—make sure they base your asset allocation on your long-term goals and objectives, not a subjective (and meaningless) measurement like a risk profile or survey. And ask how they’ll help keep you on track once that plan is in place, helping you maintain the discipline and patience so vital to investing success.

Do this—weigh all the factors that influence performance looking forward—and you’ll likely be better positioned than those who make future-impacting investment decisions based only upon the past, which is a little like forecasting yesterday’s weather. Easy and irrelevant.

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