Fund and market performance: Don’t look in the rear-view mirror

This quote is famously attributed to Peter Drucker, the well-known American consultant and management thinker.

Yet people still try, in various ways, to predict the future outcome of events, or at the least prepare for it in some way.

In the investment world, you will find a standard disclaimer on any investment product document: Past performance is not necessarily a guide to the future. Or worded more strongly: Past performance is no indication of future performance.

But, honestly, it is intuitive in your daily life to use the past as a trusted informant when making choices. Would you return to a restaurant if the food was great? Most likely. Would you order another electronic device from an online store that sent you a faulty product last time? The chances are slim.

This may be why recent research by Leeds University again showed that despite the prevalence of the abovementioned disclaimer, investors persistently used past performance to inform their decisions on mutual fund selection.

In the academic article highlighting the findings, authors Leonardo Weiss-Cohen, Philip Newall and Peter Ayton write: “Participants persistently chased past performance despite the opportunity to learn about the futility of this strategy during 60 repeated decisions with feedback.”

Roland Gräbe, head of discretionary fund management at Old Mutual Wealth, says it seems every investor who reads the disclaimer believes it is meant for somebody else.

“We all read the warning, but investors tend to do the exact opposite and rely on past performance information in their decision-making. This while we have seen empirically that there really is no strong correlation between past and future performance,” he says.

Gräbe admits that past performance does play a role in Old Mutual’s Tailored Fund Portfolios manager selection process, but only when applied very specifically to understanding the risks a manager might take.

“Interpreting the past in this way seems to be a much more reliable indicator of future behaviour,” he says.

“If a manager, for example, took a lot of stock selection risk in the past, that trend tends to continue in the future. Or if a manager has a very strong style bias, that will likely continue going forward.”

Tailored Fund Portfolios is Old Mutual’s discretionary fund manager (DFM) service offered to advisors who seek to outsource investment selection.

Asset classes vs asset managers – approach them differently

While outperformance against a benchmark by a certain asset manager in the past is not a good indication of outperformance in the future, there is value in looking at past performance to understand how a certain asset class may perform over time.

Why the difference?

Gräbe points out that markets, or asset classes, can’t have a survivorship bias where you only focus on examples of successful individuals or instances (survivors) rather than the whole. It is already a holistic picture that includes the non-survivors as well.

“If you study markets over the long term, across geographies and across multiple timelines, different asset classes tend to deliver quite predictable long-term returns. However, a specific manager’s approach usually works best in a certain environment and will only work while that environment persists,” he says.

And environments change – sometimes rapidly and unexpectedly.

Investment experts will therefore take the long-term past performance of an asset class into consideration, along with its valuation metrics, when looking for attractive markets. That thinking should however not be applied to individual managers during the manager selection process.

What about betting on some hot sectors?

If past performance is then not the way to go, perhaps it is a good idea to focus on new, up-and-coming sectors, and the asset managers who include these in their underlying fund basket?

Again, no, says Gräbe.

“You want to be very careful of hot sectors, whether this is biotech, cryptocurrencies or some new thing that seems to be attractive,” he says.

“Growing sectors attract a lot of competition, which brings new entrants, and this will ultimately push down profits.”

He believes individual investors should not spend much time thinking about sector allocation, but leave this to the investment experts. He also advises that it would be prudent to remember that life-changing new sectors or technologies do not automatically imply excess returns for first investors.

Let’s back the underdogs then

Would using a selection strategy that conversely looks at recent underperformers be the answer?

The Dogs of the Dow stock-picking strategy, for example, tries this approach by focusing on the highest dividend-yielding stocks in the Dow Jones 30 index each year. Low stock prices push the yield up and in short, this strategy works on the premise that last year’s poor performers could be this year’s leaders.

The strategy has proven successful for many, but Gräbe does not believe it’s a sure-fire plan.

“Selecting managers on bad past performance also doesn’t automatically give better results,” he says. “That is because investment performance is really complex. Performance is informed by many factors: the manager’s style, the environment, personnel changes and so on.”

Betting on the underdog, he says, is also not a feasible, long-term winning strategy.

Steady does it

Old Mutual’s DFM manager selection process centres on a few core points that remain unchanged no matter what markets do:

1. Determine whether the fund manager has a sound, logical philosophy. You have to interrogate the belief that the manager expresses around their ability to do better than a specific benchmark. Ask yourself: is it sound? Is it robust?
2. Can you understand the manager’s process? “It simply isn’t a successful recipe to invest in something you don’t fully understand,” says Gräbe.
3. Are the fees charged fair? Does it allow you to benefit from that manager if they do have skills? Empirically, low-cost funds are the better performers.
4. Look for a team-based approach, because people change jobs. If you put your faith in a single individual and you have a long-term plan, it would be devastating if they leave.
5. Beware the over-confident manager. Gräbe says any manager who believes they have the insight and answers that no one else has should be a red flag. “Overconfidence tends to be indicative of a manager who at some point in the future will get things wrong.”
6. Steer away from managers who try to time market trends. “It is notoriously difficult to predict the future,” says Gräbe. “So any manager that believes they can predict timing, inflexion points, or market movements, is a risk.”

These factors, says Gräbe, will not change over time and offer a sounder approach.

“You can apply this process as it is based on human behaviour, which is more constant over time.”

Brought to you by Old Mutual Wealth.

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