Past performance tells us very little

Past performance tells us very little

When choosing a fund, most people instinctively focus on how it has performed in the past. Yet a fund's past performance tells us remarkably little about how it's likely to perform in future. In fact, funds with an impressive short-term track record, precisely the ones you're most likely to read about in the media, are often exactly the funds to avoid.

In this video, Jeffrey Ptak, Global Director of Manager Research at Morningstar, explains why both the media and the investing public attach far too much significance to past returns. The evidence suggests this simply isn't a prudent approach, because past performance tends to be mean-reverting. What attracts our attention is whatever has done well recently, and what has done well tends to revert lower over time. That's the paradox investors face: the funds that shout loudest to us, and to which we're most likely to succumb on impulse, are often the ones most likely to mislead us.

You'll learn what factors investors should be paying attention to instead. Morningstar's research consistently shows that a far more accurate guide to future performance is how much a fund costs. Ptak explains that performance is only one, and a very small one, of five elements in Morningstar's research process. Their analysts focus far more on the things that are durably repeatable: the prudence of the investment process, the depth, breadth and continuity of the people, the shareholder friendliness of the parent organisation, and, crucially, the price. If anything has endured as a predictive variable, it's cost, which their research suggests is, if not the single most predictive factor, then very close to it.

The takeaway: identifying in advance an actively managed fund that will outperform the market over the long term is extremely difficult, and past performance won't help you do it. Choosing a low-cost index fund that tracks the whole market gives you a far better chance of a successful investment experience.

Chapters / Key points

• Why most investors focus on past performance
• Why past performance tells us little about future returns
• Why funds with strong short-term records are often ones to avoid
• What mean reversion means for investors
• The paradox of being drawn to what's performed best
• What Morningstar's research actually focuses on
• Why process, people, parent and price matter more
• Why cost is one of the most predictive factors of all
• Why a low-cost index fund gives you better odds

Transcript

Past performance tells us very little

Robin Powell: When choosing a fund to invest in, most people tend to focus on how a fund has performed in the past. The fact is that a fund's past performance tells us very little about its likely future performance. Indeed, funds with a good short-term track record, in other words, those you're likely to read about in the media, are often just the funds to avoid.

Jeffrey Ptak is the Global Director of Manager Research at Morningstar.

Jeffrey Ptak: Whether we're talking about the media or the investing public, they tend to attach quite a bit of significance to past performance. The question is whether that's a prudent thing to do, and I think the evidence suggests that it's not. And why is that? It's because past performance tends to be mean-reverting. And so, what we tend to pay attention to, what attracts notice in the media and more popularly amongst investors, is what has done well. And what has done well tends to revert lower. And so that's the paradox that we face as investors. The things that tend to speak to us the most, that signal to us the most, to which we are likeliest to succumb to impulse, are probably the likeliest to mislead us, because they revert lower over time.

Robin Powell: So, if a fund's past performance is a poor predictor of future performance, what factors should we be paying attention to? Morningstar's research constantly shows that a far more accurate gauge is how much a fund costs.

Jeffrey Ptak: We have five elements of the research that we conduct, and performance is one of those elements, but it's a very small element. What we really stress with our analysts who are going out and evaluating and managing investments is, let's focus more on the things that we think are durably repeatable. Like the prudence of the process, the depth, breadth and continuity of the people, the shareholder friendliness of the parent organisation, and then, very importantly, the price.

It has to be priced competitively, because one of the things that we've seen, if there is anything that's endured, it's the importance of price. And certainly, our research has suggested that price is, if not the most predictive variable, certainly close to it.

Robin Powell: The bottom line is that identifying, in advance, an actively managed fund that will outperform the market over the long term is extremely difficult. Choosing a low-cost index fund that tracks the whole market will give you a much better chance of a successful investment experience.