The power of mean reversion

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

940_MW_P16_Strategy

Don't buy the winners

"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.

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.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free
https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

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.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.