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Financial Happenings Blog
Wednesday, June 16 2010
One of the great traps with investing is the tendency to follow investments or asset classes that have done well in the past under the assumption or hope that they will do likewise in the future.  Jim Parker in his latest commentary piece for Dimensional highlights some research showing the pitfalls with this approach.

Stars or Straws?

Jim Parker, Vice President, DFA Australia Limited

Investors frequently seek external validation to ease the anxiety of putting their money at risk. Problem is there is no guarantee that a "five-star" rating on a chosen fund will lead to a "five-star" investment experience.

It is human nature for consumers to seek comfort in the idea that the products they are buying are proven in the marketplace. That need is met by ratings agencies that play a legitimate and vital role in providing independent assessments of various investment products.

Those assessments are made in professionally compiled and detailed reports that can be a useful yardstick for investors and their advisors in comparing funds so that they can make a fully informed decision.

But despite diligent cautions from the agencies about chasing returns, problems arise when consumers blindly extrapolate star rating systems for various funds into imagined future performance.

The risks of this approach were highlighted in a survey by US private wealth management business Burns Advisory Group, which went back to 1999 to study the subsequent 10-year performance of Morningstar's five-star funds.1

Burns found that of the 248 funds rated five-star by Morningstar on December 31, 2009, only four were still receiving that rating a decade later. Of the original sample, 87 had ceased to exist. Of those still existing, all had been downgraded to an average of just under three stars. Even worse, in all categories except international stocks, the average performance for five-star funds over this 10-year period was worse than the average for all funds.

"These findings imply the star ranking methodology leaves long-term investors in the lurch," Burns concluded. "If nothing else, it demonstrates clearly why investors should not rely on one measure as their sole research tool."

But it is not just unsophisticated investors that are chasing performance. Another recent report suggests that even wealthy individuals and institutional investors can be blind-sided by past returns.

The study by researchers at the European School of Management and Technology, quoted in The Economist magazine, looked at how investors allocated money to hedge funds over 10 years from 1994.2

The researchers found that the funds that had performed well in the previous three quarters attracted significantly more money than their competitors. In other words, the supposedly "smart money" was chasing past returns.

Bear in mind, also, that indiscriminately chasing returns can be even more costly with hedge funds, which typically charge management fees of 2% or more, plus 20% of the returns they generate for clients.

Given the large body of academic evidence that it is extremely difficult to predict market returns with any confidence, it should be evident that past returns should not be the foundation for choosing one fund over another.

Leading academics Gene Fama and Ken French, in a recent study of mutual fund performance, showed how hard it is for investors to distinguish skill from pure chance in analysing the returns of individual funds.3

So what should an investor and his or her advisor weigh up in making a decision? The key here is to focus on items within their control, such as:

  • Are the risks being taken related to return?
  • Are those risks targeted in a reliable, consistent way?
  • How diversified is the fund?
  • Does it make promises it can't keep?
  • What is more important - individual judgement or clear processes?
  • Are the underlying strategies driven by forecasts?
  • Does the fund take account of costs and taxes in its decisions?
  • Does the fund manager communicate in a clear and consistent way?

While many of these attributes can lead to good outcomes for investors, they are no guarantee of positive returns every year. Anyone who makes those sorts of promises risks disillusioning those who put their faith in them.

But the above characteristics can give investors comfort that their money is being invested in a consistent, transparent way and that ensures that when the targeted premiums kick in, they are positioned to receive them.

This is a grounded, completely defensible approach. The alternative is that by reaching for the stars, investors are left clutching at straws.

1. McGuigan, Tom and Courtenay, Tim, Star Gazing: Five Star Funds Revisited, Burns Advisory Group, April 2010

2. Buttonwood, Who's the Patsy?, The Economist, May 29, 2010

3. Fama, Eugene F., and Kenneth R. French. 2009. Luck Versus Skill in the Cross Section of Mutual Fund Returns, SSRN

Posted by: AT 06:30 pm   |  Permalink   |  Email
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