Thanks to Lipper’s latest fund industry insight report, the danger retail investors face from flooding into a sector that has been a top performer in previous years only to fall foul of a serious dip in returns has been given greater gravitas.
“The variability in the ranking of IMA sector returns over the past 30 years is such that the average ranking is close to the mid-point whether one chooses the top, bottom or middle sector from the previous year,” Lipper revealed.
Further details from the report show a mixed bag of results:
If an investor had chosen the top sector based on one year returns in any given year then, on average, holding that investment for three or five years was a more successful approach than picking the previous worst sector.
By contrast, however, picking a fund on the sector average over the past three or five years and holding it for just one year reveals investors would typically have been better off picking the worst sector.
No real pattern
Lipper found that the IMA sector with the best average one year return in each of the past 30 years on average ranks 15th out of 30 in the subsequent year. Similarly, the bottom-ranked IMA sector each year is ranked 16th on average over the following 12 months. Damning stuff for past performance practitioners.
Back in 2001 the FSA released a report of a ‘task force’ on past performance, which recommended changing the watchdog’s approach to regulation the way past performance information was allowed in financial advertisements.
The reasoning went that despite rules in place at the time prohibiting firms from making any implied or explicit connection between past performance and future prospects, research suggested consumers still make the leap of faith from one to the other.
The task force did not go as far as recommending a full-scale ban on the publication of fund or investment manager-specific past performance but it noted that some did favour such a ban.
Instead we have to make do with a catch-all phrase “past performance is not a reliable indicator of future results”, as made clear in the FSA’s Conduct of Business Sourcebook.
The FSA’s rules deal with the presentation of past performance to retail clients. But what if the real problem stems from the advisers and wealth managers putting retail clients’ money in products based on a past performance screen?
Advisers to blame
Cazenove’s head of multi-manager Marcus Brookes, has talked on this topic in the past, referring to fund buyers as ‘quantitative lemmings’.
Citing studies he had done using Lipper data, Brookes said the probability of a top performing fund over three and five years maintaining its performance over the next three to five years was minimal.
“If I was to describe some fund managers’ and IFAs’ approach to picking funds it is usually quantitative to begin with and it is obvious most guys begin with the stuff that has just done well,” Brookes said.
“A lot of people doing this are buying high and if it has just outperformed maybe it is because it is a highly cyclical growth fund or value fund and that is why it has done well. It also means you are discounting three-quarters of the sector,” he continued.
Despite FSA guidelines on past performance and its view that it is of little or no value in itself as an indicator of future performance, we have countless rating systems and fund-screening processes built on the metric.
The practice of anointing funds top quartile or deriding them as bottom quartile is another example of this at work.
Lipper’s report makes it even clearer that past performance bears little semblance to what you can expect from a sector or asset class in the future.
When will the industry start to pay attention to this lack of correlation, or is this yet another item to be put on the Prudential Regulation Authority’s to do list?
