5 Steps to Deciphering Past Performance

Trailing returns are commonly used when assessing a fund but can often be misleading; here's how to unearth a fund's more realistic potential

Christine Benz 2 January, 2014 | 3:04PM

Is it any wonder so many investors are confused? After all, so much about investing is counterintuitive: The stock of a company frequently goes up when the firm lays people off, bond prices go down when yields rise, and low fund costs tend to predict better performance.

An even bigger head-scratcher is that past performance, whether good or bad, is a poor gauge of how good a fund is likely to be in the future. That's right—just because a fund has shiny top-percentile rankings during every time period, the data suggest that it's unlikely to be able to maintain that performance edge going forward. That finding has major implications for how investors manage their portfolios. Although many look for funds with top rankings during the past five- and 10-year periods and dump their relative underperformers, they may fare better by taking the opposite tack.

The most recent research on the "is past performance predictive?" question appeared in the June/July issue of MorningstarAdvisor. Using top-quartile funds within several of Morningstar's diversified US-equity-fund categories, Morningstar Investment Services' president and CIO Jeff Ptak examined how the funds performed during subsequent five-year periods. He found that, depending on the category, just 10%-20% of the top-quartile funds remained in the top quartile of their peer groups in the future five-year periods. He also concluded that "you were likelier to find a top-quartile fund in a category's bottom half than its top half."

Does that mean you should ignore performance altogether when assessing a fund? Not necessarily. And in any case—as one of the only ways to quantify a fund's worthiness—performance is hard to ignore. But the research showing past performance as a poor predictor does suggest that investors should be more nuanced in how they choose and oversee their investments.

Consider the following before buying a fund with top-10% trailing returns during every time period, or kicking a fund you own to the curb because its trailing-return numbers look poor.

1. Dig Deeper

Trailing returns can obscure a lot of action under the surface. Taking an example from the US, Oakmark International’s trailing returns were sterling last year, landing in its category's top 10% or better for 2013 and during every long-term trailing time period. But a closer look at its year-by-year percentile rankings reveals a trajectory that's not quite as smooth as its trailing-return rankings would suggest. It posted an above-average loss in 2011, for example, and badly underperformed in 2007, as well, losing money even as other international-equity funds posted healthy gains. That doesn't mean it's not a fine international equity option—it is. But it does mean that this now-closed fund's many newly arrived investors should have their eyes open to the fact that it's a distinctive fund that will underperform its peers and indeed post above-average losses from time to time. 

Assessing a fund's calendar-year returns and rankings and rolling returns, while more labour-intensive than eyeballing trailing-return rankings, can help you set expectations about a fund's future behaviour. For equity funds, a glance at their performance during the polar-opposite years of 2008 and 2009 can tell you all you need to know about their character. Generally speaking, more conservative funds tended to hold up better than their peers during 2008, the bear market year, while more aggressive types shone in 2009.

2. Consider the Role of Risk

One of the easiest ways for a fund to climb to the top of the trailing-return charts is to make a sizable bet on one or two industries—or even a handful of individual stocks—that subsequently take off. In the 1990s, for example, Legg Mason Capital Management Value manager Bill Miller famously made twin bets on the financials and technology sectors. That led to an as-yet unmatched streak of beating the S&P 500 and, in turn, eye-popping trailing-return figures for a number of years. More recently, another US manager, Fairholme’s Bruce Berkowitz has engineered very strong returns because of a giant wager on once-beleaguered financials firms.

These and other managers clearly recognise that in order to outperform their peer groups and/or indices by a sizable margin, they must look different from them; under- and overweighting sectors or stocks by fractional amounts relative to the benchmark isn't going to cut it. But risk-taking can cut both ways, and boldly positioned funds frequently experience long spells of poor performance after their hot streaks. 

If a fund is at the top of the charts during several trailing time periods, it's more important than ever to ask questions about what kind of risks it might be taking rather than assuming the manager can keep up the winning streak. If a manager has bet heavily—and successfully—on a few stocks or sectors, try to get your arms around the prospects for those securities on a forward-looking basis. Morningstar.co.uk Premium Members can see the Morningstar Ratings for stocks for equity holdings in a fund's portfolio.

3. Ask if You're Looking at an Outlier

It's also possible that your fund has climbed to the top of its heap simply because it's no longer a good fit for that peer group. Morningstar categorises funds based on the past three years' worth of portfolios, so a fund won't immediately change categories simply because its investment style has changed during a short time frame. That means that outlier funds have the potential to climb to the top of the heap during certain trailing periods. For example, a fund may outperform its small-cap peers in a blue-chip-dominated market environment because the manager has gradually been shifting into larger stocks to accommodate asset growth. Morningstar may eventually move the fund to a mid-cap peer group if the fund continues to graduate into larger stocks, but in the meantime its trailing-return rankings can tell a misleading story. If a fund has very strong trailing returns but its current position in the Morningstar Style Box is different from its category's, take the extra step of comparing it with its style-box peers, too. Performance might be less impressive than it looks.

4. Look for the Sure Thing

In contrast with past performance, which has weak predictive ability, Morningstar's research has shown that fund expenses are the most predictive data point of all. That means that casting your lot with a fund that has strong past performance but high costs is a bad bet to make; you're better off banking on the low-cost fund with poor returns.

5. Adopt a Contrarian Mind-Set

Just as very strong recent performance often doesn't foretell strong returns ahead, the opposite is also true: The fund with very weak recent returns can end up on top. Indeed, if a fund ticks the boxes in other important respects—its strategy is sensible, its management is experienced, its costs are below-average—a spell of weak returns can signal a buying opportunity because the securities in the portfolio could be relatively inexpensive.

Using Morningstar's Fund Screener to identify funds with positive Analyst Ratings—Gold, Silver or Bronze—plus weak trailing returns can help surface unloved ideas that could be due for a rebound. Of course, there's no guarantee that these laggards will rebound, but focusing on fundamentals, while simultaneously de-emphasising recent performance, can help stack the deck in your favour.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Christine Benz

Christine Benz  is director of personal finance at Morningstar and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.

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