Which fund would you buy today, without knowing anything more about them? A top-quartile fund returning 30 per cent over three years, or a bottom-quartile fund that lost 10 per cent in the same period?
Studies, like those done by financial research firm Dalbar, suggest that investors, in aggregate, would prefer the first fund – and the typical client owning the second would sell it to buy the top-quartile product.
Fund groups, of course, would also be marketing the outperformer. On the back of this, we put forward two main points:
Clients drawn to good past performance should consider going against this instinct and buy recent underperformance. Put another way, it is the “dog lists”, of which these funds 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, such as emerging market 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. 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 (such as Dalbar’s) show that the average investor in a fund underperforms the fund they invest in by as much as 5 per cent a year because of this.
Take an example: The top-performing global equity fund over the five years prior to the 1999 tech bubble – Henderson Global Growth – was the worst performer in the sector five years later.
And the reverse is true: Gam Global Diversified moved from bottom quartile in 1999 to top quartile in 2004. This is not an isolated case – time and again we see that bottom-quartile funds over one, three and five 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 returns over the past half decade? Given they have delivered around cash plus 5 per cent over the long run, what if you invested after they delivered just 1 percentage point over this amount during a five-year period?
The average return over the next five years would be cash minus 2 per cent. And 84 per cent of the time, subsequent returns would have been below the long-term average.
These are not good odds and are also mirrored the other way: the worse the five-year return, the better the subsequent five-year number, on average.
Buying past winners is easy to understand – past performance is a common gauge of manager capability and, when performance drops, clients may believe the manager has lost their edge.