Five Factors That Trump Short-Term Returns

Investors tend to focus on short-term returns when selecting funds, but that's often a recipe for poor results. Here are five factors we believe offer you a much better chance of success.

Russel Kinnel 7 August, 2006 | 11:35AM
Picture this. It’s August 20th, the first Sunday of the season. Chelsea is at home to Man City. From the kick-off, City pump a long ball into Chelsea’s penalty area; John Terry, blinded by the bright sun, misjudges the flight – Andy Cole nips in between him and Cech and, in a flash, it’s 1-0 to City. Your friend turns round to you and says “Chelsea is just rubbish – they’ve no chance of retaining the Premiership.”

You would understandably conclude that your friend doesn't know anything about football, right? The game's only two minutes old, so how could one possibly draw conclusions about the outcome of the game, let alone the whole season?

Yet I hear the investing equivalent of those comments every single day. Equity investments are meant for the long haul, and you can't judge equity funds by six months' worth of performance when they're designed to get you to your goals 15 years down the road. But every day investors tell me that they think a fund is great because it has a good year-to-date return or maybe two or three good years. I also hear complaints that we have recommended investments that had a bad year or two.

In my 11 years at Morningstar, I've found that this sort of short-termism is far and away the most common mistake investors make. Short-termers chased emerging markets in 1993, and it took nearly 10 years for emerging markets to come back. We've also had a couple of biotech bubbles, a blue-chip equity bubble, and, of course, an Internet bubble, and I've seen investors shoot themselves in the foot each time.

When the Internet bubble burst, leaving the short-termers down 70% while savvy diversified investors were down 20% or so, I thought the experience might cure investors of the “chasing performance” disease. And for a while the prognosis was positive. I heard much more interest from investors in the management behind the fund and corporate culture and strategy, too. Except for a few hard-core performance-chasers who thought bear market funds would go up, up, up, the hot-fund buzz pretty much died away.

But with the bear market well behind us, novice investors are back to making some similar mistakes, chasing commodities, energy, and, yes, emerging markets. Most fund companies have become better about not encouraging short-term performance-chasing, but not all have seen the light.

Better to learn the lesson in a column than in your life savings, so I'll say it here: Short-term performance is mostly noise, and recent return figures provide very little guidance about what will work for the next 10 years.

With that in mind, here are five factors (listed alphabetically) that matter more than short-term performance if you're trying to predict long-term success. These are among the most important that we focus on in our qualitative analytical work, but we're always working to test factors for predictive value, and could name 10 that are more valuable than short-term returns.

Expense ratios have proved to be as good a predictor of future performance as any. The reason is that expense ratios are a constant factor in fund returns and are pretty stable. That means that through dramatic shifts in the economy, markets, and even changes in fund management, low-cost funds are going to compound at a greater rate for their shareholders and high-cost funds are going to erode returns at a greater rate.

Moreover, the managers at low-cost funds are often better paid than those at high-cost funds, so you often get better management. That may sound counterintuitive, but it makes sense when you think in dollar terms. Good managers are likely to attract more assets than poor ones, and thus tend to run larger funds, so a fee of 50 basis points on a £2 billion fund means more money in that manager's pocket than another manager who earns 100 basis points on a £100 million fund.

Long-Term Relative Performance
While short-term performance is noise, there really is valuable information in long-term performance. Yes, there's still noise in there, but managers with strong long-term records of outperforming a relevant benchmark are a pretty good bet. Most often, this benchmark will be a peer group constituted of other funds in their Morningstar category; most IMA sectors are simply too broad to provide a useful comparison.

The manager and analysts running a fund have an enormous impact on a fund's success. The fund industry is a little idiosyncratic in that you have very skilled and seasoned managers supported by brilliant analysts competing against relative newcomers with little research support. It’s therefore vital that you distinguish between quality management and the opposite case. This can be hard for individuals to assess, but it’s a topic we will cover in depth in our forthcoming qualitative analyses of funds in the UK.

When we analyse funds, we spend considerable time evaluating factors that help measure a fund company’s commitment to putting investors interests first. These might include the recruitment and retention of talented research staff; investment processes and funds that are designed to stand the test of time rather than merely leverage short-term trends that might burn investors on the downside; communication with fund owners that is clear, honest, and forthright about admitting mistakes; meaningful investment by managers in their own funds; and attention to keeping costs low.

Our work over the past twenty years in the US has shown that these types of factors have very real impacts on a fund's returns. If a manager is purely focused on making money for himself, he and his analysts are more likely to bolt from the fund at first sign of a higher bidder for their services. Likewise, a fund company that's too focused on the next quarter’s earnings is more likely to mark up fees on a variety of services as well as keep funds open long past their optimal asset sizes.

This isn't a data point: It's about knowing what you need. It's what a good IFA will help you to figure out. Even if you don't have one, though, you'll find investing is much easier when you begin by thinking about what your goals and needs are before you head for the performance tables. Consider what your investment time horizon is and your risk tolerance. And as you select investments, don’t simply consider what the best funds in each asset class or sector are, but consider how they will interact. A good portfolio will mix funds with relatively low correlations in an effort to maximize returns while reducing the risk that all your funds will under-perform at once.

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

Russel Kinnel  is Morningstar's director of fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping US investors build winning portfolios.

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