5 Steps to Deciphering Past Performance

Trailing returns are commonly used when assessing a fund but can often be misleading; here's how to unearth a fund's more realistic potential

Christine Benz 07.02.2014
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Is it any wonder so many investors are confused? After all, so much about investing is counterintuitive: The stock of a company frequently goes up when the firm lays people off, bond prices go down when yields rise, and low fund costs tend to predict better performance.

An even bigger head-scratcher is that past performance — just because a fund has shiny top-percentile rankings during every time period, the data suggest that it's unlikely to be able to maintain that performance edge going forward.

The most recent research on the "is past performance predictive?" question appeared in the June/July issue of MorningstarAdvisor. Using top-quartile funds within several of Morningstar's diversified US-equity-fund categories, Morningstar Investment Services' president and CIO Jeff Ptak examined how the funds performed during subsequent five-year periods. He found that, depending on the category, just 10%-20% of the top-quartile funds remained in the top quartile of their peer groups in the future five-year periods. He also concluded that "you were likelier to find a top-quartile fund in a category's bottom half than its top half."

Does that mean you should ignore performance altogether when assessing a fund? Not necessarily. And performance is hard to ignore. But the research showing past performance as a poor predictor does suggest that investors should be more nuanced in how they choose and oversee their investments.

Dig Deeper
Trailing returns can obscure a lot of action under the surface. Taking an example from the US, Oakmark International’s trailing returns were sterling last year, landing in its category's top 10% or better for 2013 and during every long-term trailing time period. But a closer look at its year-by-year percentile rankings reveals a trajectory that's not quite as smooth as its trailing-return rankings would suggest. It posted an above-average loss in 2011, for example, and badly underperformed in 2007, as well, losing money even as other international-equity funds posted healthy gains. That doesn't mean it's not a fine international equity option—it is. But it does mean that this now-closed fund's many newly arrived investors should have their eyes open to the fact that it's a distinctive fund that will underperform its peers and indeed post above-average losses from time to time.  Assessing a fund's calendar-year returns and rankings and rolling returns, while more labour-intensive than eyeballing trailing-return rankings, can help you set expectations about a fund's future behaviour.

For equity funds, a glance at their performance during the polar-opposite years of 2008 and 2009 can tell you all you need to know about their character. Generally speaking, more conservative funds tended to hold up better than their peers during 2008, the bear market year, while more aggressive types shone in 2009.

Consider the Role of Risk
One of the easiest ways for a fund to climb to the top of the trailing-return charts is to make a sizable bet on one or two industries—or even a handful of individual stocks—that subsequently take off. In the 1990s, for example, Legg Mason Capital Management Value manager Bill Miller famously made twin bets on the financials and technology sectors. That led to an as-yet unmatched streak of beating the S&P 500 and, in turn, eye-popping trailing-return figures for a number of years.

More recently, another US manager, Fairholme’s Bruce Berkowitz has engineered very strong returns because of a giant wager on once-beleaguered financials firms. These and other managers clearly recognise that in order to outperform their peer groups and/or indices by a sizable margin, they must look different from them; under- and overweighting sectors or stocks by fractional amounts relative to the benchmark isn't going to cut it. But risk-taking can cut both ways, and boldly positioned funds frequently experience long spells of poor performance after their hot streaks. 

If a fund is at the top of the charts during several trailing time periods, it's more important than ever to ask questions about what kind of risks it might be taking rather than assuming the manager can keep up the winning streak.

Ask if You're Looking at an Outlier
It's also possible that your fund has climbed to the top of its heap simply because it's no longer a good fit for that peer group. Morningstar categorises funds based on the past three years' worth of portfolios, so a fund won't immediately change categories simply because its investment style has changed during a short time frame. That means that outlier funds have the potential to climb to the top of the heap during certain trailing periods. For example, a fund may outperform its small-cap peers in a blue-chip-dominated market environment because the manager has gradually been shifting into larger stocks to accommodate asset growth. Morningstar may eventually move the fund to a mid-cap peer group if the fund continues to graduate into larger stocks, but in the meantime its trailing-return rankings can tell a misleading story.

Look for the Sure Thing
In contrast with past performance, which has weak predictive ability, Morningstar's research has shown that fund expenses are the most predictive data point of all. That means that casting your lot with a fund that has strong past performance but high costs is a bad bet to make; you're better off banking on the low-cost fund with poor returns.

Adopt a Contrarian Mind Set
Just as very strong recent performance often doesn't foretell strong returns ahead, the opposite is also true: The fund with very weak recent returns can end up on top. Indeed, if a fund ticks the boxes in other important respects—its strategy is sensible, its management is experienced, its costs are below-average—a spell of weak returns can signal a buying opportunity because the securities in the portfolio could be relatively inexpensive.


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About Author

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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