Navigating the perils of past-performance tables

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The Independent Online

Here is a paradox. How can an investment fund be both one of the most successful performers in the recent past and yet disappoint most of its investors by delivering below-average returns? The answer is: surprisingly easily. This time the reason hasvery little to do with the old bugaboo, fund costs, but a lot to do with the dynamics of the managed fund business.

Here is a paradox. How can an investment fund be both one of the most successful performers in the recent past and yet disappoint most of its investors by delivering below-average returns? The answer is: surprisingly easily. This time the reason hasvery little to do with the old bugaboo, fund costs, but a lot to do with the dynamics of the managed fund business.

The clue to the riddle is that most new money tends to arrive in a successful fund on the basis of past performance at precisely the time when replicating that performance is hardest for the fund manager.

For an insight into this phenomenon, which applies equally to unit trusts and investment trusts, I am indebted to the research and performance consultants, the WM Company, from whose recent research I have taken the graphs that accompany today's column.

The research comes from a report commissioned by Virgin Direct, but the implications go beyond the simple issue of active versus passive management that it set out to address. What the graphs show is a more detailed breakdown of the performance of some of the funds that repeatedly show up in any analytical exercise designed to find that small handful of funds which can claim to have consistently outperformed a relevant market index over any length of time.

The graphs shows, first, the year by year performance of three of the funds that have outperformed the All Share Index over a 10-year period in the UK All Companies sector, and, secondly, the same performance when viewed on a three-year rolling basis (that is to say, for each year it shows the performance of the fund over the previous three years). All the performance figures are relative to the performance of the FTSE All-Share index over that time period.

Only 20 of the 144 funds actively managed unit trusts in the survey were able to pass this test after allowing for all costs. The degree of outperformance relative to the All Share index ranges from 6.6 per cent per annum in the case of ABN Amro UK Growth to 2.2 per cent per annum for Johnson Fry Slater Growth, and 1.8 per cent per annum for three other very well known successful funds, Jupiter UK Growth, Newton Income and Schroder UK Enterprise (the last two of which are not shown here for reasons of space).

These five funds also enjoy a positive rating from Standard & Poor's Fund Research, which means they have passed qualitative tests and a tough performance screening. In other words, these are genuinely high-quality funds deemed to be among the best in the business.

Interesting points arise. One is the obvious one that is visible just from comparing the one and three- year rolling returns. It makes a difference which one you choose to look at. The second obvious point is that all the funds have had bad years as well as good ones, and all suffered periods when their three-year rolling returns have lagged the market.

The third point is that while some funds (for example, ABN Amro UK Growth in the early Nineties) have demonstrated consistent performance relative to the market for years, there is considerable divergence in the extent to which single years are responsible for most of the longer-term track record. This is especially obvious in the case of the ABM Amro Fund and the Johnson Fry Fund, whose excellent track records both depend very heavily on a single year's exceptional performance (1999 and 1997).

In Schroder UK Enterprise, managed for many years by Jim Cox, the reverse is also unfortunately true. His fine long-term track record, with seven consecutive years of outperformance from 1990 onwards, dramatically fell apart in massive underperformance in 1997-98.

The problem for fund managers who put together an exceptional year is that this is hard to sustain, at least when you know the background story. The Johnson Fry Slater Growth Fund owed its spectacular performance in 1996 to the arrival of a new manager, Jim Slater's son, Mark, who revamped the portfolio and produced stunning early gains. Until the fund suddenly started to motor again a few months ago, he has inevitably found it less easy to repeat the performance.

Yet this was the period when the fund has taken most of its new money. Early in 1997, the fund had £50m under management - now it has £220m. The new investors who came in since the end of its spectacular first year under new management have had to wait until the past few months to see significant returns on their money, though itis fair to point out that as of today the fund is once again ahead of the All Share Index on a three-year basis.

There is a similar story at Jupiter UK Growth, where the size of the fund has grown from about £100m to nearly £600m in the past three years, a tribute to the phenomenal marketing skills of Jupiter, and it has made life easy for the manager. His investors will have to wait before they see a return to the exceptional relative performance of the past.

In one sense, it is invidious to single out these funds because they are among the best around, but it does demonstrate a more general truth that applies even more strongly to the rest of the field.

Because investors rank past performance so highly, regardless of warnings, they tend to arrive in numbers at the moment the fund is least likely to do as well as it has done, a phenomenon also evident in the new issue history of the investment trust business.

Part of this is simply a function of the difficulty of handling sudden large inflows of funds. Even the best fund managers struggle to sustain their performance when they are hit by large inflows of money, which they have to invest regardless of present market conditions. This is particularly true of funds invested in an aggressive way and according to a particular investment style that has worked well for a while, but is now going out of favour.

There are ways to turn the situation to one's advantage. As I have suggested before, one is to wait for highly regarded managers with a particular style to go out of favour and buy their funds then, when their performance looks relatively poor and the hot money is going elsewhere.

This would have worked particularly well with Newton Income when it had two bad years in 1995 and 1996, and may also work well for the Schroder UK Enterprise Fund, though here the situation is complicated by the retirement of the manager, Jim Cox. On this basis, the Jupiter UK Growth Fund shown here may also be due for a recovery before too long.

In this, as in everything else in investment, there are merits in adopting a contrarian approach. It is just a fact of life in this business that whereas money always follows performance, performance does not always follow the money.

Which is why a lot of investors end up with money in funds that have apparently fantastic long-term records - but whose benefits stubbornly fail to show up in the performance of their own portfolios.

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