The most important number to look at before you buy any fund

Many investors get distracted by past performance when they buy a fund. But there’s something else to consider that will have a much bigger influence on your returns.

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Don't get too hooked on a fund's past performance

I've just read some interesting research from data provider Morningstar.

It looks at whether private investors are any good at market timing or not.

I won't spoil the surprise for you right now, but I'm guessing you might have a hunch as to what the answer is.

The bigger question is what can you learn from this?

We are all terrible at timing the market

Data provider Morningstar looked at three-year rolling returns from a wide selection of US equity funds (covering all styles, from large-cap value stocks to small-cap growth stocks) from the start of 1996 to the end of 2018. The researchers also looked at growth (or shrinkage) in the assets under management.

In other words, they pulled out how well or how badly funds had done performance-wise over any given three-year period. And they were also able to get a good idea of whether customers were investing more money, or pulling their money out of these funds.

As a result, they were able to examine how past performance influences the average mutual fund investor's tendency to buy into or sell out of a fund.

Take a wild guess at what they found. No, really, have a guess.

That's right. Investors are just absolutely woeful at timing the market.

They tend to buy into a fund (they "hire" it, as Morningstar puts it) after it has enjoyed a period of performing well. They sell out of funds (or "fire" them) in periods after they have been performing badly.

This would be perfectly OK if the trends continued. But they don't. Just as investors have reached the point of maximum pain (that moment when they can no longer bear to be out of a successful fund, or to keep their money invested in an underperforming fund), performance has a horrible tendency to switch.

As Morningstar reports, "the performance of hired funds eroded post-hiring, while fired funds saw their performance improve." In other words, on average, investors buy and sell funds at exactly the wrong time.

Why does this happen? This is "regression to the mean" in action. Here's how it works.

Beating the market is hard. Very few people can do it consistently. And while it definitely involves skill, it also involves a lot of luck. As a result, outperformance in one year probably doesn't indicate that you've spotted a fund management genius. It probably just indicates that you're an average fund manager with above-average luck. And luck, unlike skill, doesn't last.

As a result, on average, an average fund manager who has enjoyed above-average luck is going to see that outperformance come to an end.

The problem is that investors extrapolate from past performance. So they expect (or hope) for performance to carry on in a straight line. But in fact, it moves in cycles, or waves. So, put very simply, what goes up must come down, and vice versa.

Don't buy before you check this number

What does this imply for investors? First things first if, as an investor, you are genuinely buying funds simply because you've noticed that they are going up in value, then you have no business making investment decisions on your own behalf.

Seriously. That's no kind of criteria on which to pick a fund. You are damaging your future wealth by acting in such a cavalier manner with your life savings.

If this describes you, then what you have to do is go and educate yourself about index tracker funds, fund costs, and asset allocation, then find a suitable balance of cheap tracker funds and invest in them regularly. Don't check your portfolio too often, leave to simmer for 20 years, and you should have a decent retirement pot at the end of it.

(You could also get an online wealth manager or an adviser to do this sort of thing for you the key then is to pay attention to what they're charging you.)

Say that this isn't you. Can you put this information to use to make contrarian bets? After all, it implies that buying funds which have been doing badly might be a good bet.

That has a certain appeal. However, when you look in more detail at the Morningstar data, even the turnaround funds (and the successful ones) still, on average, slightly underperform the index (not by much, but a little bit of underperformance is not what you're paying for).

So the real question becomes: why use a fund manager at all?

Now, I happen to think that there are sometimes compelling reasons to use a fund manager. There are fund structures out there which encourage longer-term thinking I'm thinking investment trusts mainly and there are successful managers who have a clearly communicated, well-considered strategy in mind, one that you won't be able to get from a tracker fund.

(The MoneyWeek investment trust model portfolio contains six such trusts subscribe now if you don't already.)

These strategies will not outperform every year nothing does but if you understand and agree with their rationale, you can at least make an informed decision as to whether you want to buy for the long run or not.

However, if you are simply looking for exposure to a certain market, or theme, then your first port of call should be to look at what's available on the indexing side of the business.

Why? Because a good index fund is cheap, and it will deliver the average return. Most "actively-managed" funds under-deliver, not because fund managers are bad at their jobs, but because their cut is too large. Once you've paid their costs, it's very hard to do anything but underperform.

So that's what to take from this research. Don't get distracted by past performance. Look at what you're being charged. The latter will have a much bigger impact on your returns than the former.

John's book, The Sceptical Investor, is out now MoneyWeek and Money Morning readers can get 25% off by clicking here.

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