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Seek Poor Performers
Which fund would you buy today, without knowing anything more about them?
|3 year Return||Quartile|
|Equity Fund A||30%||1|
|Equity Fund B||-10%||4|
Studies, like those done by Dalbar, suggest that investors, in aggregate, would prefer Fund A – in fact if they owned Fund B, the average client may sell it to buy into Fund A. Fund groups, of course, are also marketing Fund A, rather than Fund B.
On the back of this, we put forward two main points, both related:
- Clients drawn to good past performance should consider going against this instinct and buy recent underperformance (Fund B). Put another way, it is the “dog lists” of which fund B would form a part, that are probably the most fertile source of future ideas, rather than the funds getting the awards.
- The same applies to asset classes and investment styles. Today we see reduced flows into out-of-favour asset classes, like emerging equity or debt, with savings directed to those asset classes that have done well – developed market equity and debt. We could say the same about equity styles: quality is in vogue, not value and this should give investors pause too. Again, we suggest that poor past returns favour prospective investors over time.
On the first point, the results can be surprisingly significant. For example, over 20 years, the average client in a top quartile S&P 500 fund underperforms the bottom quartile of funds because of their buying and selling pattern. And, quite depressingly, studies (like Dalbar) show that the average investor in a fund underperforms the fund they invest in, by as much as 4-5% a year because of this.
Take an example: If you purchased the top performing global equity fund (Henderson Global Growth) over 5 years in the IA Global sector, leading up to the 1999 tech bubble, it was the worst performer in the sector 5 years later. And the reverse is true: had you owned GAM Global Diversified during the tech bubble, it moved from bottom quartile in 1999 to top quartile in 2004. These are not isolated cases – time and again, we see that bottom quartile funds over 1, 3 and 5 years, on average, end up being better bets than those at the top.
What about asset classes? Should you buy UK equities after they have delivered strong cash beating returns over 5 years? Given they have delivered around cash + 5% over the long run, what if you invested after they had delivered cash + 6% over 5 years, just 1% above this average? The average 5 year subsequent return would be cash – 2%. And 84% of the time, subsequent returns would have been below cash plus 5%, the long-term average. These are not good odds and are also mirrored the other way: the worse the 5 year return, the better the subsequent 5 year number, on average.
Buying past winners, whether funds, styles or asset classes, is easy to empathise with – past performance is a common gauge of the capability of the manager, particularly when referenced against peers. And when performance drops, clients may well believe that the manager has lost their edge. Furthermore fund groups, on average, sell the most recent winners and their marketing budgets are large. But, in the end, evidence suggests that being contrarian and betting against the marketers and top quartile rankings is best. On average, it’s a loser’s game if winners are backed once they are on the podium already.