The danger of chasing returns

Past performance is not an indicator of future performance. We read and hear this on every financial product, but do we heed the words? I would suggest not. Go to a rating website for managed funds or a fund manager's website on its own and what is the first thing we do when judging a fund? Look at the performance.

Ranking funds by five-year performance is the accepted norm but a report just released by S&P Dow Jones Indices, presenting research in the age-old debate of passive vs actively managed portfolios (also read Billionaire Buffett takes an active swipe), suggests that maybe we are looking at this the wrong way.

The Persistence of Australian Active Funds report found that of the 74 Australian Equity General funds in the top quartile in 2012, only 1.35 per cent remained in there after five years. In the Mid and Small-Cap space the report found 4.17 per cent of funds in the top quartile remained after the same period. Over a three-year period 6.67 per cent of Australian Equity General funds remained in the top quartile, and 12.50 per cent of Mid and Small-Cap funds. Interestingly, none of the International General Equity top quartile remained on top in the five-year period.

Across Australian Equity General and International the report found more funds in the top quartile at the start of the five-year period did not just drop out of the highest quartile but dropped all the way down to the bottom quartile. It's tough at the top.

Thinking about the asset classes the funds are investing in, the larger the market capitalisation of the stocks the more coverage they receive. This would indicate there is little edge a manager can gain to consistently beat their opposition.

The report shows in the Mid and Small-Cap space far more top-performing funds remained in the top quartile. This would make sense as there is less analyst coverage of smaller stocks, giving an investment team with a sound process a greater edge over the rest of the competition.

It is interesting to note of the Australian Equity General funds surveyed over a five-year period which started in the bottom quartile; 20 per cent made it into the top quartile by the end of period compared to 21.74 per cent for the Mid and Small-Cap funds.

The strategic approach to investing

What does this mean for investors? Don't chase returns. The highest-performing funds are in the top quartile for a reason.

The investment process historically identified good opportunities, but that process may not work across different economic environments. Do not head to the bottom of the table either. Picking underperforming funds can be as dangerous as picking stocks that have halved or more. Sometimes they are cheap for a reason.

Greater importance needs to be placed on the investment process and understanding how a fund manager selects stocks and manages a portfolio. Investors who are looking for a managed product need to ask more questions to get past the jargon. Don't settle for the same trotted out lines, “we're top down, bottom up stock pickers”.

Reports like the one quoted in the article help fuel the broad statement that most investors are better off in an index fund.

For those prepared to not understand and monitor their investments, that may be the case. But if you are looking at a managed product you need to place responsibility on yourself and not just blame the manager if you underperform.

For my approach on how to pick active and passive investments, you can see me present at the upcoming Australian Shareholders' Association national conference in May and at our InvestSMART Investor Sessions.