Imagine three funds. Over the last three years, Fund A has produced stellar returns, Fund B’s performance has been mediocre and Fund C has underperformed. Which fund are investors most likely to want to invest in? D’oh! Fund A. It’s a no-brainer.
Now ask yourself, if you sold funds for a living, say you worked for a fund shop or a brokerage firm, which fund would you find easier to sell? If you were a journalist writing about the different funds available, which fund’s manager would you choose to feature in your article? If you edited an investment magazine or a slot on a financial TV channel, and you needed some expert analysis, which manager would you ask? Of course. Fund A wins every time.
Now consider the question, which fund — A, B or C — is likeliest to outperform in the future? According to a new study of US equity fund performance, the answer is in fact Fund C — that’s right, the fund that’s underperformed for the last three years. The next best returns are likely to come from Fund B, the one with a mediocre recent track record. Counter-intuitive though this might seem, it’s Fund A — the hot fund that everyone’s talking about — that is likely to deliver the lowest returns in the future.
The study was conducted by three distinguished US academics and its findings are contained in a paper entitled The Harm In Selecting Mutual Funds That Have Recently Outperformed. It should be compulsory reading for investment professionals and journalists alike. No doubt, like most of these studies with “off-message” conclusions, it will attract nothing like the attention it deserves in the industry.
This latest research, which is broadly consistent with the findings of previous studies, has two important implications for investors. First, selecting a fund on the basis of past performance is a bad idea. But, if you are going to do it, you’re better off selecting recent losers than winners.
Secondly, superior investment performance is more a function of investment style — systematic exposure to different types of risk — than a manager’s talent or expertise. Skill, in theory, is repeatable, but investment styles come and go, which explains the tendency towards mean reversion.
More importantly for me, the study lays down a challenge to investment professionals and to the financial media: It might be in your interests to encourage investors to follow their natural instinct to chase performance, but it isn’t in theirs.
Advisers, isn’t it time to stop churning your clients’ portfolios every two or three years, depending on who the latest star managers are?
Investment consultants, why keep advising the fund trustees you work for to hire the winning managers and fire the losers when the evidence shows they’d be better off doing the opposite (or, better still, buying and holding low-cost index funds instead)?
And journalists, why keep putting so much emphasis on short-term outperformance that has more to do with investment style, or simply random chance, than manager skill?
Yes, it might mean reassessing your business model. It may require you to have a long hard look at what your motivations are. But if you really have the best interests of investors at heart, you surely have no option.
Related posts:
Just because it looks like skill doesn’t mean it is
Vast majority of UK fund managers “genuinely unskilled” — study
New funds are designed to sell, not to make you prosper
Short-termism — why the whole investment industry is to blame
Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.
