THESE days, the average investor relies on fund performance data to evaluate, buy or sell unit trust funds. He may scrutinise his funds ranking on Lipper, or the Standard & Poors fund performance data. However, he may not be aware that this may lead him to make unwise investment decisions.
When selecting an appropriate fund, many investors are unsure of how to select a fund tailored to their investment needs. Many investors fall into the trap of buying into a fund solely based on its past performance. They assume that if the fund has done well, it will continue to earn the same amount of income distribution or returns every year.
The rationale behind this is simple: Investors have easy access to past fund performance data from the business sections of newspapers, and as such, it is a very convenient way to gauge the ranking of a fund.
Of course, past fund performance data may, to some extent, be used as a guide in selecting funds. However, if it is the sole criteria in selecting a fund, then you are not getting an accurate picture of how the fund has performed.
There are other key aspects worth considering for a better understanding of a funds performance. The most important point is that past performance data is not a measure or guarantee of a funds future performance.
Past performance could be a poor indicator of future success
The debate is not about the accuracy of such data, but the reliability of using past fund performance data alone in making investment decisions. One should consider several factors.
Firstly, past fund performance data provide a funds performance at a specific period in time. Therefore, the funds performance only reflects the performance of a period and it does not take into account the funds achievements outside this period. For example, a balanced fund could have performed well in a selected period, but may have been lacklustre at other times.
Secondly, a funds good performance within a specific period may be due to favourable market conditions and not the fund managers skill. As such, looking at a funds performance solely to determine a fund managers strength does not completely and accurately reflect the managers true potential. An investor should also gauge his performance in a bear market.
Another flaw in over-focusing on the historical rate of returns of a fund is that it ignores the qualitative factors that contribute to the likelihood of a funds future performance. For example, a funds performance is partly due to market conditions. Market conditions may change, and using past fund performance may no longer be accurate. In addition, the fund managers ability to manage your fund in new market conditions may not have been tested in the past. So, there is no way of knowing if your manager can deliver expected rate of returns when market conditions change.
Your fund manager may be inexperienced in dealing with unfamiliar market conditions and is therefore likely to make unwise investment decisions. All these subjective factors are important in determining a funds future performance and cannot be discovered when solely relying on a funds historical rate of returns.
Finally, the past rate of returns of a fund may be attributed to the fund managers team, which may change from time to time. A skilled fund manager who had been responsible for a funds past performance may have left, and as a result, the funds future performance may suffer.
As such it is important to familiarise yourself with other criteria to help avoid the pitfalls of over-relying on a funds historical rate of return.
Scrutinising performance measurement
Fund managers often look at a funds rolling period returns. In a nutshell, the rolling period returns is defined as the average of a funds rate of returns over several fixed rolling periods in a particular time frame.
This is useful, as it evens out a funds performance and fluctuations over various cycles to more accurately reflect a funds true performance.
Do bear in mind that when using rolling period returns, a sufficiently long track record should be considered. There is no hard and fast rule of what the investment length should be, but it should be sufficient to include a few market cycles. This is to assess a fund managers ability to manage different market situations. A longer period would also help allow identify any mistakes performed by the managers. Also, fund managers may have particular investment styles that work well in certain market situations. You should assess your funds performance over a period of three to five years. Rolling period returns are also useful in measuring a funds consistency in delivering rate of returns.
In examining your fund managers performance, you should also consider different market conditions such as a bull or bear market separately. You can then determine whether your fund manager has fared better in poorer or more favourable market conditions. This information can be useful in helping you select and rebalance your portfolio holdings as market conditions change.
The information ratio is another useful quantitative indicator to measure the value-added input of a fund manager. The information ratio calculates a funds ability to consistently outperform its peer group over a fixed period in various market cycles.
Another factor that you should consider when assessing a funds likelihood of success is the fund managers track record and experience. You should determine who the fund manager is, whether he is able to manage your funds proficiently and if he has the experience of managing funds in difficult market conditions.
A diligent investor should also closely examine the fund managers team, or the investment firm as well as the investment process involved. Ask questions like: Are investment decisions dominated by a single star performer, or are such decisions a team effort?
You should also monitor the calibre and turnover rate of the staff. For example, if the investment decisions were dominated by a single star performer, and he suddenly left the team, this could severely impact ture performance.
Another useful criterion you should consider is the organisational culture of the investment company. Organisations with a strong culture and investment approach tend to nurture talented fund managers with better investment skills. Such an organisation will likely have funds that are stronger performers than their peers, leveraging on their extensive experience and culture.
You should also look at the discipline in investment approach adopted by the fund managers. Frequent changes in investment decisions may result in inconsistent performances and this makes it difficult to gauge the visibility of future performance.
Fund managers who frequently change their investment objectives without a clear goal are unlikely to have exceptional performances. Past performances from such an investment strategy could be unreliable and it may be difficult for investors to determine if such a fund manager will ultimately succeed.
In conclusion, one of the most misleading clichés of investing is to believe that past fund performance is the sole indicator of future fund performance. Always remember that there is no single magic indicator that can determine a funds future success.
No one can predict the future, and to attempt to do so would prove foolhardy to the investor. The best anyone can do to approach investing is to gather valuable information to make an informed professional decision about how a fund is managed.
·The above views reflect those of Citibank Bhd as at the date of publication. They are intended for general information and/or discussion of the topic. They are not intended to be relied upon in any way by any investor in foreign currencies or other investment products.
While every effort has been made to ensure accuracy of the information, no liability whatsoever will be accepted by the bank or the author whether in contract, tort or otherwise, for any error of fact or omission herein which may lead to any direct or consequential loss arising from any reliance upon or use of this report. Investors should seek independent professional advice before making any investment or taking any course of action towards investing.
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