It makes sense to buy duds

Past performance is not an indicator of future returns, or so says the warning sign on every investment prospectus you're ever likely to read. Yet a fund's return history could be one of the best guides you have as long as you pick the duds, rather than the managers who are enjoying a hot streak.

In The Folly of Hiring Winners and Firing Losers, Rob Arnott, Vitali Kalesnik and Lillian Wu of Research Affiliates note that institutional investors typically dump a fund after roughly three years of underperformance, while private investors "are frequently even less patient". They then usually reinvest in a fund with a more impressive recent track record. That might feel like a logical way to sort the wheat from the chaff, but more often than not, it's a bad move.

Arnott and colleagues looked at US equity-fund returns from 1990 to 2016. They found that those who ranked in the top 20% in terms of performance over the previous three years went on to underperform the bottom quintile by about 1.1% a year over the subsequent three years.

Try 6 free issues of MoneyWeek today

Get unparalleled financial insight, analysis and expert opinion you can profit from.

Start your trial

Sign up for MoneyWeek’s free twice-daily newsletter.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Sign up

In other words, the managers at most risk of being fired were also the ones most likely to be on the verge of a solid recovery. The key to all this is that while some managers are genuinely good or bad at managing money, "persistent manager skill is rare". The difference in performance is driven mainly by different styles ("factors" in the jargon) becoming more or less decisive.

Put simply, individual managers tend to favour specific investment styles value, say, or small caps. These factors tend to "mean revert" over time. In other words, when a factor becomes expensive, it's heading for a fall, while cheap factors eventually turn around.

So if you sell a fund after it's been doing badly for several years, the chances are that it's due a turnaround assuming the manager hasn't been forced to change strategy under pressure from disgruntled clients, that is. As the Research Affiliates team put it: "the longer a winner has been winning, or a loser losing, the higher the likelihood of residual reversal prevailing and rewarding the contrarian".

This doesn't mean you should hangon to perennial underperformers. But it does mean you should think twice before selling or buying based purely on past performance. What's key, says Arnott, is valuation. If a fund manager has had a bad run, but now owns assets with "record-low valuations", it's time to buy.

Similarly, if you own a fund that has done well, but the manager owns expensive assets and has no plan to sell and look for cheaper ones, you should get out. It may go against the grain, but "in investing, we generally find our best rewards in our discomfort zone".