Yahoo Finance Why You Should Ignore a Fund's Recent Performance
Hidden in the fine print of every mutual fund or exchange-traded fund fact sheet, you'll find a phrase that goes something like this: "Past performance is no guarantee of future results."
This disclaimer is required by the Securities and Exchange Commission, but it also contains a good reminder for anyone who's choosing portfolio investments.
Most of the time, some kind of performance data will have a prominent place in a fund's literature. Even when a fund has underperformed its benchmark recently, marketers know how to present the data in a way that draws attention to the most favorable numbers. For example, you might see a chart that illustrates a hypothetical investment over time, or tables arranged in such a way that the best performance data appears first.
Marketers go to these lengths because they know investors are drawn to the performance numbers.
But that doesn't mean a fund that's performed well lately will continue on the same trajectory. In its Persistence Scorecard, published in December 2014, S&P Dow Jones Indices found that only 5.84 percent of actively managed large-cap funds finished in the top half of their category over five consecutive 12-month periods.
For mid- and small-cap funds, those numbers were 2.83 percent and 7.95 percent, respectively. Randomness would account for a repeat rate of 6.25 percent, according to the report.
"There's no correlation between past performance and future performance, yet when it comes down to making an investment decision, that's what people look at," says James Osborne, president at Bason Asset Management in Lakewood, Colorado.
Osborne notes that investors sometimes have to work hard to get any information other than performance. He recalls helping a client evaluate investment options in a 401(k) account. The statement provided by the plan had scant information.
"It had a list of funds, had no categorization, no benchmarking, no index performance, and was literally just the trailing performance of every fund in the plan. I was dumbfounded. What information is the investor supposed to use to make a decision about how to invest their 401(k) money? They have to use past performance information, because that's all they were given," he says.
Human nature also factors into performance-chasing, says Louis Barajas, founder of Wealth Management Lab in Santa Fe Springs, California. When comparing their results with what others got, investors don't want to feel they chose poorly or missed an opportunity.
"People are comparing their portfolios to their sister-in-law's. She got 10 or 15 percent, while they only got 7 percent. But the sister-in-law didn't mention how her portfolio did in 2008, and that also leaves out diversification. There are so many variables beyond just looking at last year's performance," he says.
Barajas uses a number of tools to show clients why performance-chasing may be hazardous. A favorite is a colorful chart that illustrates year-to-year returns of various asset classes. Clients can see there is no discernible pattern for performance of investments such as emerging market stocks, large-cap value stocks or real estate investment trusts.
He cites emerging markets, which can be particularly volatile, with wide year-over-year changes in performance. For example, the MSCI Emerging Market Index declined 18.42 percent in 2011, but was up 18.22 percent the following year.
"That shows people why it's important to not look at past performance, but instead to maintain a well-diversified portfolio in different asset classes, tied to the time frame of their goal," Barajas says.
Tim Dreiling is a senior vice president and managing director at U.S. Bank's wealth management unit, the Private Client Reserve, in Prairie Village, Kansas. He says the financial services industry and financial media play a role in keeping investors focused on past performance.
Despite financial advisors' best efforts to steer clients away from a focus on short-term results, people are still drawn to recent investment returns and don't look at the bigger picture. That's particularly true when it comes to the recent returns of a large-cap U.S. index, such as the Standard & Poor's 500 index.
"None of us can help it," Dreiling says. "We turn on the news and every other day, we get treated to a report that the stock market hit a new high today. You're talking about one measure of all the capital markets, and that's what investors are spoon-fed every day. That's the one number people know and ask about."
At the end of 2014, many investors holding diverse portfolios looked at returns of the various asset classes and wondered why advisors urged them to stick with the laggards. "There were big disparities between a handful of asset classes that did OK and many that were lackluster at best," Dreiling says.
Osborne also acknowledges the difficulties in keeping investors from making performance-based decisions. Because information about index and fund performance is so readily available, advisors must take extra steps to educate investors about factors that contribute to total return over time. He refers to a 2010 Morningstar study, which showed that low-cost funds consistently outperformed higher-cost funds.
"People should know about the Morningstar study: The only predictor of future results is expenses. Nothing else has a statistically significant impact," he says. "So let's control things we can control. How tax-efficient is this fund? What are the internal costs related to a higher versus lower turnover rate of the fund? Let's help people understand how those things translate to higher real after-tax returns, and be less focused on the headline return numbers."
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