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Fund Research & Insights

The Folly of Short Term Performance

Buying funds based on short-term past performance is often a losing game.

Christopher J. Traulsen, CFA 27 May, 2008 | 11:20AM
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Investors often buy funds based on past performance, especially of the short-term variety. This is in part human nature--behavioural finance types might attribute it the tendency all of us have to try to impose order on chaos, even if it means attributing meaning to small patterns where there may be none. It may also be a matter of convenience--getting reliable information about fund holdings, management, and organisational factors such is incentive pay can be difficult. In the face of that difficulty, investors tend to place more weight than they should on easily available factors, such as short-term past performance.

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.

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.

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About Author

Christopher J. Traulsen, CFA  is director of fund research, Europe and Asia, Morningstar.

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