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The power of mean reversion

When it comes to investing in funds, don’t chase the top performers – look for the cheapest ones.

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"Past performance is no guide to future performance." That's what the warning signs on marketing literature always tell you. And yet both professional and private investors have a hard time letting go of history when it comes to choosing which investments to buy. Studies in the past have already shown that institutional investors tend to buy funds that have a recent track record of beating their peers and selling the ones that don't. And a more recent study from data provider Morningstar finds that the same is true for the likes of you and me.

Starting in 1996, Morningstar looked at three-year rolling returns on a wide range of US equity funds, covering all styles of investing, up until the end of 2018. The researchers also looked at growth (or shrinkage) in the assets under management. This gave them a good idea of how popular or how loathed funds were at any given time. As a result, they were able to gauge how the three-year past performance of a fund influences the average fund investor's decision to buy or sell it. What they found is predictable after a fund has done well, investors are more inclined to buy, and after it has done badly, they tend to sell.

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This would be perfectly OK if the trends continued. But they don't. It turns out that the warning is true typically, a fund that has endured a three-year underperformance starts to turn around just as investors are selling in droves, while funds that have done well tend to be most popular with investors just as their time in the sun is ending. In other words, your average investor be they institution or private individual buys and sells funds at precisely the wrong moment. This is "regression to the mean" in action. The reality is that beating the market is hard and the average fund manager cannot do it consistently. So if a fund has done well for a few years, it is more likely due to luck rather than skill. And luck doesn't last: hence the cycle of disappointment.

You might think the lesson here is to invest in a contrarian manner buy funds that are currently losers and avoid the ones that are winners. Normally I'd agree, but the Morningstar data obscures something rather more fundamental even the funds that beat their peers rarely beat the market after fees are taken into account. So the real question is: why pay an expensive fund manager at all, if you can find a cheaper way to access the same market? We're not saying that you should never use active funds (we're keen on certain investment trusts, for example). But unless there's a compelling reason to use an active manager (for exposure to a certain strategy or sector, say), then given the choice between a cheap tracker and an active fund, opt for the tracker every time.

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