We have evidence from the US market (a) that fund investors there routinely hurt themselves with such behaviour, and (b) that the more volatile or specialised the fund,
the more investors are likely to damage themselves by chasing short-term performance. And when we say "short-term"--this may come as a shock--we don't mean six months. Generally speaking, we would think of anything less than five years as short-term.
Given the propensity of UK investors and their adviser to rely on short-term performance figures from a set of what amount to broadly dawn peer groups in the IMA sectors, we thought we'd take a look at just how predictive top ranks are in the core IMA UK Equity sector, UK All Companies. To do this, we examined rolling three-year returns dating back to the end of 2002. Whilst far from a comprehensive survey, the results show that even during a period when momentum was extremely strong buying on near-term performance wasn't a good idea.
If we were to rank the sector by their three-year returns in 2002, and track the top quartile of funds going forward, we can see the following: By 31 December 2005--three years later--23 of 37 funds that had been in the top quartile were no longer ranked in that group, 12 had fallen into the sector's bottom half, and 4 had fallen into the sector's bottom quartile. If we move forward to the end of 2007, 25 of 37 had fallen out of the top quartile, 22 of 37 (60%) were in the sector's bottom half, and 15 (41%) were in the sector's bottom quartile.
If we start closer to the present, the results look equally scattered. Out of 46 funds with top-quartile three-year returns at 31 December 2004, only 16 could boast returns that remained in the sector's top quartile at 31 December 2007. Fifty per cent of those 46 top-quartile funds went on to deliver bottom half returns over the next three years, whilst 13 posted results that ranked in the sector's worst quartile over the next three years.
Study after study shows that investors harm themselves by chasing past performance. There will be periods where it actually works for a period of time. This is usually during extended momentum-drive markets. Examples include the strength of small-and mid-caps that ended in mid 2007, and more recently, the commodities rally. The problem is that this too must end, and if you are investing based on past performance, you may well be caught in the backlash.