When Does Past Performance Not Equal Future Returns?

question markWhy does every mutual fund and ETF advertisement in big letters advertise their RETURNS and then directly under it put something like the following?

Past Performance Cannot Guarantee Future Performance.

  To see a list of high yielding CDs go here.  

The short answer is that they are required to put up the disclaimer by their regulators. However, this disclaimer requirement has always struck me as odd. If putting up your past performance is so misleading, why not ban the process of putting up past performance numbers entirely?

The truth is that looking at past performance is critical to understanding the likely future performance of a fund. However, looking just at the absolute % gain or loss of a fund in isolation can be misleading. There is a lot more information needed than just the performance number. Here are some questions which will help you determine if the past performance will likely continue into the future:

 

Was the fund lucky or good?

You can be lucky and make money. You can be smart and make money. The difference of course is that a lucky fund manager is less likely to generate great returns in the future. To assess whether a fund manager is lucky or good, you need to do 3 things:

  1. Look at returns over 1, 3, 5, and 10 year periods.
  2. Compare those returns to similar funds.
  3. Compare the fund’s volatility to its returns, using a measure like the sharpe ratio.

A fund manager that has great returns over long periods of time is probably very skilled. We want to see returns for different time periods for two reasons:

  1.  To find out how the fund did during different market conditions. For example, the five and ten year results will include the financial crisis. Some managers do well when the market is going up but, not down.
  2. We want to see recent results to make sure the manager hasn’t lost their touch. Strategies that worked a few years ago might not work well now.

We want to see how the manager did compared to his / her peers to prevent being fooled by a good looking return number. For example, 10% sounds like a great return. However, if funds with a similar focus did better then the manager no longer looks as good. Conversely, a fund that did 2% when it peers lost money might be worth considering.

We want to make sure that the manager is not a reckless gambler. Bad poker players don’t always lose money. However, if you look at their stack of chips compared to a skilled gambler, you will notice their pile will rise and fall much more quickly than a good player.  A good player will take much fewer risks to accumulate winnings. The good player will have both fewer big wins and fewer big losses.  The sharpe ratio or treynor ratio enable you to measure the volatility of a fund’s returns versus its returns. In broad terms, a sharpe ratio below one is bad and over 3 is great.  However, you should look at these ratios compared to similar funds.

 

Will the fund continue to be able use the strategies that drove past performance?

  • A fund’s strategies may change if there is a new portfolio manager
  • When a fund grows in size, it may need to change strategies.

From the outside, its hard to tell how much impact a fund manager has on a fund’s performance. For smaller fund’s, a change in manager may radically alter its performance. On the other hand, the loss of a manager in a larger fund may not be as significant an event, as the manager is part of a larger team including analysts, strategists, and traders that all influence portfolio decisions. However, even for a large fund, a change of manager can mean a tremendous loss of knowledge and skill. Will the new manager live up to previous manager’s track record? Only time will tell.

A manager that does well with a small fund, ie less than $500 million in assets, doesn’t always do as well when the fund grows in size. With a small fund, there are lots of small relative value opportunities. A manager can make great returns by being a great investment picker without taking a strong view as to the overall macro-economic environment. As a fund grows, managers tend to run out of great ideas on where to put money. Instead, they must make calls on the direction of interest rates .  Thus, sometimes as a fund grows its performance changes.

 

Will the asset classes which the fund invests continue to do well in the future?

Most funds have a particular area which they can invest, such as intermediate term government bonds or high yield. A fund’s performance has a great deal to do with the type of assets it can invest in.  If the category in which a fund invests doesn’t do well, that fund will generally not do well.

Which asset classes will do well in the future? The future is both easy and difficult to predict. For example, I strongly believe that over the long term bond funds in general will not do well as interest rates are likely to rise. However, my crystal ball is a lot more cloudy when it comes to the near future.

Rather than trying figure out which asset class will do well in the future, I suggest that you work on protecting yourself from any asset class dragging down your portfolio. In other words, you should build a diversified portfolio which includes stocks, bonds, commodities and international investments.

For more on investing in bond funds visit our Free Guide to Investing in Bond Funds here.

To see our top rated bond fund picks go here.

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