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Past performance is not a guide to the future

Rob Morgan
Being wary of very strong performance and backing funds following drab returns can make perfect sense argues Rob Morgan

‘Past performance is not a guide to the future’ is such a ubiquitous phrase in investment literature that it’s easy to skate over it and not reflect on its meaning. On the one hand it seems obvious the future is going to be different to the past, but many investors are inclined to target strong performing investments to try and ‘ride’ short term momentum. This can be a dangerous strategy as no trend lasts forever.

Since the Global Financial Crisis, investors have increasingly favoured ‘growth’ stocks capable of above-average growth in their earnings and profits as opposed to ‘value’ stocks whose share prices trade at low valuations in relation to the assets of the business. This trend seems to have been fuelled by low interest rates as investors have been increasingly willing to pay up for company earnings deemed to be of ‘high quality’, in other words their income streams are stable, fairly certain for long periods and robust enough to withstand shocks. Against low interest rates and lean yields on bonds these reliable dividend payers have appeared enticing.

Yet having benefitted from low interest rates this subset of stocks could be vulnerable to them increasing. We would therefore urge caution against tilting a portfolio too heavily in this direction. Investors often sell funds once they have underperformed the market over the past two to three years, typically replacing them with funds or managers that have recently outperformed. This seemingly sensible strategy, intended to identify skilled managers, is often bad for future returns.

No doubt some of the recently stellar funds’ managers possess strong stock picking skills as well as being in the ‘right’ part of the market. We would, for instance, categorise Terry Smith ofFundsmith Equity Fund as adding significant value on top of being a beneficiary of investors’ increasing preference for ‘quality growth’ stocks. However, for others it may be a case that luck has played a larger part than skill. As well-known investor Jeremy Grantham put it, “What passes for brilliance or incompetence in fund management is often the ebb and flow of investment style”.

Performance can affect your investments

Some fund managers have gone recently further still, claiming that the stock market mood is currently being dominated by ‘momentum’ – the propensity for what is going up to continue going up, and for what is not going up to continue to languish. Passive funds or trackers have benefitted from this, indeed they might even contribute to the phenomenon. Weights in their portfolios are dictated by size and as investors push up the values of certain stocks trackers have to buy more of them.

It is for these reasons we do not give up on certain funds that are recent laggards against their benchmark or peers. Recently disappointing managers often provide exposure to assets, factors, and strategies that have become inexpensive and are positioned for near-term success. Investments can become relatively expensive after periods of great performance, and get relatively cheap after periods of poor performance. When an area, factor or strategy is cheap relative to its own history, it tends to perform well going forward, while valuations that are high relative to historical norms predict subsequent underperformance. Thus backing a good fund manager following a drab period can be a worthwhile strategy.

Valuation and risk

This is partly explained by the relationship between valuation and risk. High valuations mean that negative surprises are highly punished while low valuations mean any upside surprise can lead to high returns. Valuations are not a good indicator of short-term returns but are a good signal of risk. Therefore if you are mindful that stock market valuations are high a logical step would be to target funds with a high ‘active share’ – i.e. they have little resemblance to the market benchmark – and preferably those that have lagged due luck not skill (or lack of it).

Many ‘value’ orientated managers have had a tough time but argue that the disparity that has opened up in stock market valuations provides a significant opportunity for ‘mean reversion’ – the propensity for returns to move back towards their average – as the anomaly unwinds. Neil Woodford, for instance, recently described the recent divergence in performance of different parts of the market as “an opportunity the likes of which he has only seen two or three times during his 30-year career.”

Whether he turns out to be correct we will have to wait and see. There are dangers in being too orientated towards ‘value’ stocks as companies residing in this part of the market are often the ones under most pressure from wider structural trends and technological change. We make no such predictions about the future – only that it will be different from the past. This is why our fund selection process takes account of the impact of investment style on returns and why a wide variety of funds can be found on our Foundation Fundlist of preferred investments, encompassing different outlooks and approaches. As a consequence there will likely be laggards as well as leaders in terms of recent performance.

This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplemental Information Document and/or Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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