Picking funds based on past performance

By now, we are all familiar with the risk warning about past performance not being a reliable guide to future investment returns.

Making investment fund selection decisions on past performance alone is a mistake most investors know to avoid.

A fund that has delivered strong performance in one year can quickly fall to the bottom on its sector in the following year. Good fund performance is usually not a repeatable trait, at least not consistently.

According to a new study from FE, relying on the three year track record of an investment fund is a particularly bad idea.

The study examined those funds that launched in 2006, finding that those that exhibited first quartile performance at their three year anniversary were more likely to be in the fourth quartile at their fifth anniversary.

Of the 43 investment funds launched in 2006 that had first quartile performance on their third anniversary, only 12 (less than a third) were still in the first quartile on their fifth anniversary. 13 of the funds were in the fourth quartile.

The study demonstrated that there was actually a better result to be had by picking a fund with fourth quartile performance on its third anniversary, with 14 of these funds delivering first quartile returns at their fifth anniversary.

If past performance alone is an entirely unreliable guide when selecting an investment fund, what are the alternatives?

Our approach to fund selection aims to select funds that demonstrate consistent above-average returns combined with low costs. We achieve this by scrutinising every investment fund in each IMA sector using our bespoke quantitative screening process.

Our quantitative screening looks at performance, consistency, charges, fund size and risk factors, along with other metrics.

Of course fund selection is one of the last steps in the investment decision making process.

Asset allocation decisions have a much larger impact on portfolio performance; regardless of whether you manage to select the best or worst fund, the allocations you make to the underlying asset class will determine the performance of your investment portfolio to a large extent.

Strategic and tactical asset allocation decisions, along with fund selection, are equally as relevant for active funds as they are for passive or tracker funds. Investors need to make decisions based on a wide range of factors, rather than past performance alone.

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