are simply buying because the fund has performed well in the past, you could be running a fools errand. Here’s why.
High returns often equal high risks
The hottest performing funds in bull markets tend to be the most volatile, and therefore most risky. For example over one, three and five years, Gartmore China Opportunities
, Threadneedle Latin American , and JPM Natural Resources are amongst the top performers. However these funds have three-year standard deviations (a statistical measure of risk) of between 20% and 26%. By that measure, these funds are two to three times as volatile as the FSTE All Share Index, which has a standard deviation of 8.55%. Accordingly, when these funds do eventually come back to earth, it won’t likely be a soft landing. Consider Invesco Perpetual Latin American. During a six month stretch from April through September 2002, it plunged over 40%. True, shareholders who held on during this drop have more than made up for their losses since, but many investors don’t have the stomach to hang on during such extreme downturns.
Past performance is no guide to future returns
To quote Warren Buffet “the investor of today does not profit from yesterday's growth”. But even though we are frequently told that past performance is no guide to the future, many investors still switch into the latest hot offerings just before the inevitable slump in performance.
Morningstar has recently conducted research into the area of investor returns. These are also known as dollar-weighted returns, and measure how the typical shareholder fared by incorporating cash flows in and out of the fund. The study showed that investors often make their entry and exit into and out of funds at the worst possible times, typically buying after a period of sustained outperformance, and selling after a period of sustained underperformance. The study also showed a link between high volatility funds and poor investor returns. The tech rally of the late 1990s provides a relatively recent example. Investors ploughed their money into technology funds right at the peak of the market, only to get a harsh lesson in the perils of performance chasing when the bubble burst. The investor return data from the US shows the typical investor in a technology sector fund over the past 10 years has lost 3.5% per year, whilst the average fund in the sector has returned a positive 6.4% per year. This suggests investors lost a whopping 10% a year through poorly timed decisions.
We could be seeing the same thing playing out with property funds. In recent years, high performance has made these funds one of the must-have portfolio accessories. However, lately their risks have been on display, and performance chasers who recently jumped aboard are now looking at big losses. The Norwich Property Trust, for example, which invests directly in bricks-and-mortar property, is down 13.86% year to date, while Aberdeen Property Share has fallen a staggering 36.38% over the same period, making it one of the year’s worst performers across all Morningstar categories.
Conclusion
Chasing performance can be extremely harmful to your returns over time. Few, if any professionals have shown any ability to consistently time investment in to and out of the market over time, and the costs of trading funds only make matters worse. A well diversified portfolio that is designed to meet your investment goals whilst remaining within your risk tolerance is a far better solution, and much likelier to result in long-term investment success than trying to buy yesterday's winners.
