Past performance is no guide to future performance. This mantra accompanies all investment ads showing how fabulously well a fund has done recently, raising the question of why it is worth advertising the past performance.
The answer is two-fold. First, there is relatively little else to go on since fund managers cannot make any fast promises for the future, which is what investors really care about. Second, it is all but impossible to resist the lure of dramatically good performance. Who would not want to invest in a fund that has outperformed all of its peers in the past three years?
Anyone who gives it more than a cursory thought, that’s who. Although many investors are swayed by evidence of excellent recent performance, statistically, it is unlikely that fund managers will manage to do well consistently over a period of years.
”There is some evidence that last year’s winners tend to repeat next year. But it is very slight. Mostly the effect comes from the fact that really bad funds stay bad. Their expenses are high, and their choices stay haphazard,” said Paul Samuelson, an academic, in his article ”The Long-Term Case for Equities”, which appeared in the Journal of Portfolio Management in 1994.
However, this does imply that it is worth considering performance, if only to avoid the poor performers.
The first thing to look at, when presented with the performance of an investment fund, is whether this is absolute or relative. An annual return of 15 per cent sounds quite good, but if the market invested in rose by 20 per cent, it sounds less impressive. In that case, the manager’s skill, which is what the fees are for, has subtracted from rather than added to the performance.
Most funds now report performance relative to a benchmark, whether this is a broad-based market index such as the FTSE 100 or a narrower index representing just a sector. In recent years, indices have multiplied to include industrial sectors, styles such as value or growth investing, different countries or regions. This means that it is important not just to look at the relative performance (has the manager done better than the benchmark?) but also to ask whether the benchmark is appropriate.
Appropriate in this case means both offering a reasonable standard for comparison with the fund’s stated aims and means of achieving those aims, and appropriate to the investor’s own purposes. The fund may say, for example, that it aims to outperform a small-cap benchmark, but if it does that by investing in huge blue chip companies, then the benchmark information is meaningless
A number of ratings systems offer some help in deciding whether the headline performance a fund manager reports is useful or not. Morningstar, Lipper and Moody’s are the big names, with Morningstar’s ratings having a huge influence on investment flows in the US. Other sources of ratings include the FT fund ratings service, Bestinvest, OBSR and Citywire. The last rates fund managers rather than the funds themselves.
Any useful fund rating service will offer more than raw performance rankings. A rating system can tell you how well managers did against their benchmark, how much risk they took to get there, how consistently they have performed in recent years and how precisely their investment style has corresponded to the chosen benchmark.
For more in-depth performance analysis, an investor has a variety of tools available. Most investment funds now publish other metrics such as the Sharpe ratio. This measurement assumes that there is a risk-free rate of return, which an investor could access by, for example, holding government bonds. For a higher return, it is necessary to accept some level of risk, usually in the form of volatility. The Sharpe ratio describes how much excess return you are receiving for the extra volatility you endure for holding a riskier asset.
In simple terms, the Sharpe ratio is calculated as the difference between the average rate of return of the investment and the risk-free rate, divided by the volatility of the investment.
Another metric is the information ratio, which performs a similar calculation, but instead of comparing the investment returns with the risk-free rate, it compares them with the returns of an appropriate benchmark. Thus it measures not just whether the investor is being rewarded for extra risk, but also how much the manager’s skill is adding to the returns in comparison with an index fund.
As absolute return funds and even hedge funds become more mainstream, another metric is also used. This is value at risk (Var), which measures how likely portfolio losses are, based on statisical analysis of historical price trends and volatilities. This measurement must be used with caution, as many fund managers calculate it using assumptions that mean that it adds no further information than the Sharpe ratio.
When choosing an investment fund, performance is important. But it is also important to bear in mind that even excellent performance can be eaten up by investment management fees. A cheap index fund might do better for the investor than a well-managed active fund, so performance should not be the only consideration.
