Secrets to making the right choice

That's even the case when you have outsourced your stock picking to a professional via investing in a managed fund. Your fund manager chooses the shares, but you choose the fund manager. And that replaces one problem with another - how do you figure out which investment house will be best with your hard-earned cash?

Isolating an outperforming manager is no minor issue. Dedicated readers of Smart Investor Money will recall our article in June that revealed barely two in every five large-cap funds (those that invest in the biggest listed companies) had beaten their benchmarks in the previous three years, according to Standard & Poor's analysis.

Most of our equities money is in the larger, "core" Australian equities funds. And that means you need to be smart about how you go about picking a manager.

Unfortunately, too many of us are doing it the wrong way. In particular, we focus excessively on how a fund has performed and not enough on forming a more nuanced view on how we think it will perform.

Raise your hand if you've heard the phrase "past performance is not a reliable indicator of future performance". Now raise your other hand if an investment manager's track record plays a central role in your decision of whether to choose it over another. The fact that most of us are reaching for the sky right now is what you get when a warning becomes so rote that we start filtering it out - much like smokers and the graphic warnings on cigarette packs.

But as is the case for smokers, the warning to not chase past performance "really does mean something", Jonathan Ramsay, head of asset consulting at van Eyk, says. He set out to prove just that.

Ramsay identified 10 instances where managers beat the market by 5 percentage points annually over three years. Did a three-year period of outperformance give a good guide to future performance? Absolutely not.

"Even looking at the best track records over the past 20 years, more often than not you'll be disappointed if you invested solely on the basis of past performance," Ramsay says. "Experience suggests that there is either a reversal or a plateau."

On these results you would actually be better picking a manager that has underperformed in the previous few years.

Yet anecdotally and intuitively, high-performing funds tend to attract more money - and the longer they outperform, the more cash they bring in. That means many will get in too late in the story and their returns will suffer as a result. It's the old curse of "buying high and selling low".

The key is to think of it in terms of valuation, because that's the cornerstone of most professional investors' processes - they want to buy companies at the point when the market underappreciates the potential for earnings growth. A fund that has been on a tear for quite some time may have been riding a trend that is almost on its last legs. A good manager should dump the stocks where value has been realised and reinvest in underappreciated companies. Yet history suggests many don't - why not?

"They're people," Ramsay shrugs, "and in practice it's quite difficult to do."

Partly it's psychological: it's hard even for the pros to cut loose a cherished winning stock. "These are [investments] you feel good about and which have served you well," Ramsay says.

So what's the best approach to selecting a manager? First off, as we've established, don't obsess about past performance.

Next, have a look at how the research houses such as Lonsec, Morningstar, and Zenith rate the fund - managers will advertise their rating if it's a good one and those agencies consider a wide range of factors, not just performance.

Finally, you need to take a view on what the world will look like in the coming few years and then choose a manager whose style and portfolio reflect your opinion. A few years back that would have meant having a bias for managers who invest in "quality" stocks - ones with sustainable earnings and strong balance sheets. That suited the volatile and range-bound sharemarket. But after a strong run, will that story continue? It may, if the troubles in Europe, China and the US worsen then they will remain the kind of funds you want exposure to. But if not, then a manager that is relatively overweight in cyclical sectors - such as discretionary retail and miners - could be the star performers in coming years.

And even if these managers continue to lag the market in the short term, at least you'll be prepared and won't be tempted to disinvest at the worst time.

"The Platinum International Brands Fund struggled a little bit at times, but when you did get that cyclicals rally early in the year they outperformed markedly - a little bit of a sign there," Ramsay says.

Of course, you can outsource your outsourcing, as it were, by letting your financial adviser pick the fund for you. Even then you need to spend time finding an independent and savvy planner.

Ramsay sums it up: "The manager is actively managing a portfolio on your behalf, so you need to take a little bit of ownership". Or a lot.