And then there is the caution from the investment industry: “Past performance does not indicate future returns”.
Most people take the first three warnings to heart, because the risks are obvious and well-documented. But the last tends to be discounted, much like the rare side-effects of your prescribed medication.
The industry’s clients do so at their peril. This financial health warning is necessary not just because future market returns are unknown, but also because the performance of individual fund managers is erratic, and ‘performance persistence’ is low.
‘Performance persistence’, the ability to consistently deliver an above-average return, is the main justification of choosing expensive active management because average returns are readily available through low-cost index funds. But such consistency is rare. Studies show that most top-quartile funds don’t stay at the top for very long, with the odds of remaining a top-quartile fund decreasing as the time horizon lengthens.
To do so would require skill in the art of stock picking and/or market timing. The absence of any famous market timers anywhere in the world discredits the latter; and a well-known US research paper concluded that 99,94% of fund managers showed no evidence of genuine stock picking skill either.
Without these skills, there can be no reliable outperformance. Locally, no fund manager has consistently delivered above-average results. In fact, most struggle to beat the average stock market return (less than 12% managed to do so over the five years ended June 2018). When some funds do outperform over the long-term, it is far more likely down to chance rather than skill. As chance is random, there is no reliable way to pick the future winners. It’s also the reason no active fund manager will ever guarantee outperformance.
This complicates the industry’s marketing, which needs to suggest the prospect of outperformance, without breaking any laws. Hence the vague statements about ‘consistency’, ‘earned trust’, or investment wisdom assimilated since before the rinderpest.
Historical performance charts – published selectively – serve the same purpose. Some funds deliver outlandish returns in the early years, abetted by their small size and excessive risk taking. This initial performance creates the illusion of long-term outperformance, even if the return in recent years had disappointed.
But there is one metric that investors should consider in their fund selection: investment costs. The evidence shows that lower cost funds have a higher success rate (measuring the percentage of funds that survived and outperformed their category group) than more expensive funds.
Difficult as it is to beat the market before fees, it’s even harder after fees, and even more on higher fees. The industry tries to gloss over this uncomfortable truth by focusing on the exceptions, trumpeting the after-fee return of a select few funds.
The problem is that fund managers do not guarantee their returns, only their fees. Or as Warren Buffett put it in his most recent annual letter to shareholders: “Performance comes, performance goes. Fees never falter.”
Investors should control what they can of their future return. Essentially that is their asset mix (the balance of growth and defensive assets, according to their investment time horizon), the degree of diversification and the fees they pay.
No amount of studying the past performance of active managers will reveal the managers who will add additional value through stock picking or market timing. Advisors and industry marketers who imply otherwise are dishonest and are not treating customers fairly.
