Chasing past performance…
Investors are often inclined to select investments based on past performance. The expectation is that top-ranked funds will continue to deliver the best performance.
Sadly, a fund’s past performance offers limited insight into its future returns.
Research shows that most funds ranked in the top 25% based on five-year returns don’t remain in the top 25% over the next five years. In fact, only about one in five equity funds stayed in the top-performing group, and only about a third of fixed income funds did.
Research presented by Dimension, one of our chosen investment fund providers. The sample includes US-domiciled, USD-denominated open-end and exchange-traded funds (ETFs).
This is because investment funds often have a ‘style’ bias or rely on a fund manager’s stock picking ability. A style bias weights specific financial characteristics to create a smaller pool of investments to choose from or add extra money to.
As you would expect, there will be times when a specific investment style is in favour or a stock-picker’s companies ‘come in’, at which time those funds could be top quartile performers (top 25%). But equally, if the style falls out of favour, top-performing funds can easily be in the bottom quartiles the following year.
There can of course be extended periods of time when a fund remains in the top quartile. The style or stock-picks may simply remain in favour, or the funds’ ‘outperformance’ relative to their peers was so big over a short period that their top ranking is maintained when looking at performance over five years.
Neil Woodford’s UK Equity Income fund was a good example of this. He managed the financial crisis of 2008 splendidly well (relatively) but subsequent performance was just OK. When he turned his hand to investing in different markets, the shine of 2008 was not recreated and many investors have lost money from the fund’s more speculative investment selections.
It is important to know why investments have performed well in the past.
This will allow you to judge whether you think they will perform well in the future. But the future is uncertain so even the best assessment can be wrong in hindsight.
As a result, constantly jumping from one past top-quartile fund to another can be an expensive mistake. Meanwhile, the compounding return of investments that perform more consistently relative to their peers has a powerful positive effect. Investing with diversification across countries and industries are a couple of steps towards achieving this.