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Why you should not use past performance for decision making

BusinesswomanDevising a successful fund selection strategy is not easy and many advisers fall into the trap of using recent past performance data in their decision-making process.

Unfortunately, explicit performance screens or implicit ones such as reliance on quartile ranking, crowns or star ratings provide virtually no help in the search for funds that outperform.

The problem is that intuitively you would expect there to be some relationship between recent performance and future performance. Manchester City may not win the Premier League next season, but the fact they won this year makes it probable that they will do well next season.

This does not work for funds, there are too many variables, some of which are very sensitive. As a result, using past performance will leave advisers just banging their heads against a brick wall.

What next for multi-asset?

We can demonstrate this using a simple scatter chart. Taking data from the IA UK All Companies sector (from which we exclude any funds benchmarked against the FTSE 250), funds are ranked according to their three year performance over 2014 and 2016. These can be plotted against how the same funds ranked in 2017.

If past performance has any predictive value we should expect the good funds in 2014-6, to go on to do well in 2017 and be grouped together. Conversely, the funds that did badly in the prior three years might be expected to continue to struggle over 2017. The chart below illustrates what actually happens:

Even with the statement that “past performance is no guide to the future” blazoned on every regulated factsheet that we have ever read, the complete randomness of the result is striking. It makes little difference what periods are considered or which IA sector. Banging your head against a brick wall is a painful experience, yet many advisers are using fund selection processes that are fundamentally flawed and just don’t work. The upside is however, life starts to feel a lot better once you realise this and you stop hitting your head on a wall.

Here is what we look for when we rate funds:

Philosophy: 

Any manager needs to articulate where the opportunities exist in the market and what anomalies he is looking to exploit. Fund buyers need to be aware of any academic evidence backing the approach, the likely persistence of the opportunity, and the reasons why the anomaly keeps appearing.

Process:

The process should describe how a manager intends to exploit the opportunities in a systematic and repeatable manner. Some processes are highly defined and rigid, others are operated with far more pragmatism. Different strategies require different approaches, there is no ideal approach.

Resources and environment:

The key to generating a differentiated performance is a differentiated approach. The people, the firm’s culture and the resources available may well be the key determinant of this. There are many ways in which a firm can differentiate itself in this regard and examples might include: the quality and experience of the staff, the firm’s ethos, the support available to the managers such as analysts and marketing specialists.

Investment Uncovered: Hargreaves-backed manager on thriving under pressure

We believe that it is important for fund analysts to meet face-to-face with managers since this is often the only way to uncover identify some of the soft skills required in the business, e.g. lateral thinking, a passion for investment and a committed focus on where the manager’s edge lies.

Understanding the fund’s objective and how this meets the outcomes sought by investors: 

It is easy to underestimate the importance of the fund’s objective when evaluating a fund. A good analyst will ensure that the objective is realistic and suitable for the fund’s strategy. The objective should describe the purpose of the fund and be of help to investors seeking to determine the suitability of the product. Investors have investment goals and the objectives should clarify the outcomes the strategy will meet.

Portfolio construction and risk management: 

The portfolio construction and the risk controls should be compatible with the performance objectives. Poorly constructed risk controls can hamper the fund when the opportunities are at their greatest or encourage risk taking at times when the latent risks are high. Attention should also be made to ensure that the manager’s best ideas receive prominence in the portfolio; this is not always the case.

Performance assessment: 

Performance should be monitored and it should be consistent with the fund’s objectives. An analyst should recognise that the variance of returns in markets is wide and that unforeseeable events occur. By having a solid understanding, both of the theoretical and practical aspects of the managers approach, coupled with a thorough understanding of what is happening in financial markets, an analyst should be able to determine what represents a good and bad record.

Cost:

Cost should be assessed versus value added. Value is provided by both the access gained to the market and the value added by the fund managers. The value of the former has been largely commoditised by the widespread introduction of passive funds. Value added by fund managers is potentially very valuable to investors though it is not prevalent.

Transparency and access:

Trust needs to be built between a manager and his clients and a continued dialogue is helpful in this regard. Regular contact is required and over the last few years pressure on the managers’ time has intensified. Only those analysts who have maintained excellent relations with fund management groups are likely to obtain access with many of the best and most popular managers in the industry.

Jason Broomer is head of investment at Square Mile Investment Consulting & Research

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