Is past performance a useful guide for future returns?

When it comes to investing in funds, looking at past performance data is very alluring and is the starting point for many. Because of this, despite the required disclaimer at the bottom of every piece of investment marketing material, stating that past performance is not a guide to future returns, most investors find it difficult not to rely on it.

The temptation for many is to select funds based on past performance data because it is easy to understand - unlike much of the other financial criteria and research available to supposedly help investors choose.

Certainly, when looking at your investment options, it is more important to examine current trends, rather than past ones. It is how to do that - and make an informed decision - that can be more difficult. So what should you do about past performance data?

Despite the ubiquitous compliance disclaimer, it is clear that past performance can be a very helpful tool in the investment selection process. However, it is not a divining rod and should be used with caution – and in the correct way. And it should not be the only selection criteria.

For example, as in the recruitment process, a fund manager’s track record is instructive and past performance can be used to assess fund managers. You can check to see how they have performed against their benchmarks. If they consistently beat them, then it would seem reasonable to expect similar outperformance in future.

Drilling down further, you can get to understand a manager's approach, as well as the types of conditions in which he or she is likely to outperform. You also need to evaluate whether a strong performance will continue when market conditions change. Further, you need to assess whether underperformance is due to a manager losing his mojo, or whether it is simply due to the fund's strategy.

It is not easy, however. As an example, perhaps the most famous fund manager of them all is the contrarian Neil Woodford, once of Invesco Perpetual and now running Woodford Investment Management. He avoided technology stocks like the plague during the dot com bubble in the late 1990s and allegedly nearly lost his job in the process. Yet he was proved right long-term. Selecting his funds going forward would have seemed a bold decision at the time.

The same can be said of sectors, where past performance could well cause a few moments of unease. For example, Lipper IM shows that Emerging Markets were the best performing sector for two consecutive years in 2009-10 but then became the worst performing sector in 2011. In 2015, it was again the worst performing sector but jumped to be the best again in 2016. Obviously, investments should be made for the long-term but this level of volatility could cause palpitations. It shows once again the benefits of diversification.

In summary, despite the disclaimer, past performance is still a useful guide in assessing the effectiveness of a fund manager and his/her strategy. However, it needs to be put into context. What risks did the fund manager take to achieve that return? Did he/she just get lucky with their top holdings? What do the pattern of returns say about a fund manager’s investment style? Can the numbers be reconciled with the fund’s stated investment approach? How has the fund performed during sharp rallies and market downturns? How great have the divergence of returns been when compared with the benchmark and its peers?

So you need a fair bit of detailed understanding to gauge which fund managers are going to succeed in the future. This is where expert financial advice comes in.

If you wish to discuss this or would like advice on your investment portfolio, contact Kellands.


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