Investors frequently turn to a fund's past performance as an indicator of future potential when making investment decisions. A fund that has consistently delivered impressive returns over several years may seem like a safe bet for continued success.
However, seasoned investors are well aware of the familiar disclaimer: ‘Past performance is not a guide to future returns’. This statement reminds us that relying on historical returns can be misleading. In this article, we explore the concept of performance persistence and consider whether a fund’s past performance can offer any real clues about its future success.
WHAT IS PERFORMANCE PERSISTENCE?
Performance persistence refers to the ability of a fund to consistently outperform or meet its benchmark over multiple time periods. If a fund has shown strong returns in the past, the concept of persistence suggests that this success may continue due to factors such as manager skill, strategy or market positioning. The idea behind persistence is that a robust investment approach or sound decision-making can deliver consistent results.
However, many factors contribute to performance that cannot be controlled and not all gains are repeatable. For example, a fund may do well in a bull market but underperform when conditions shift. It's also critical to differentiate between short-term persistence - such as strong returns over a single year or quarter - and long-term performance, which reflects consistency over five or 10 years. Investors should focus on this longer-term persistence rather than being overly influenced by short-term results.
THE DISCLAIMER: PAST PERFORMANCE IS NOT A GUIDE TO FUTURE RETURNS
The widely used disclaimer ‘Past performance is not a guide to future returns’ and its variants exist for good reason. Markets are unpredictable and changes in economic conditions, government policy or global events can dramatically alter the landscape. While past performance can provide some context, it is not a reliable guide for what lies ahead.
One major reason behind this disclaimer is that market conditions are constantly evolving. A fund that performed well in one type of environment may struggle if those conditions change. For example, a fund that thrived during a period of low interest rates and economic growth might not do as well if rates rise or the economy slows. The strategies that were successful in one period may not be effective in another. Investors who rely on past returns alone may be caught off guard when performance dips as the environment shifts.
There is also the issue of survivorship bias. Poorly performing funds often close or merge into better-performing funds, making it seem like persistence is more common than it is. Funds that no longer exist due to underperformance are removed from performance datasets, giving investors a skewed view of the remaining funds, which often show better results.
Thus, while past performance may offer clues about a fund’s strategy and the environments in which it has thrived, investors should approach these figures with caution.
EXAMINING HISTORICAL PERFORMANCE: WHAT TO LOOK FOR
Despite the disclaimer, there are ways to analyse past performance that can help investors assess whether a fund is likely to continue performing well. The key is to look beyond headline return figures and dig into performance metrics that reveal more about the fund’s consistency and risk profile.
One such metric is alpha, which measures a fund's return compared to a benchmark index after accounting for the risk involved. A positive alpha indicates that the fund manager has added value beyond what would have been expected based on the level of risk taken. However, high alpha does not always guarantee future performance, as it may reflect market conditions that temporarily benefited the strategy.
Another important metric is beta, which measures a fund’s volatility relative to the overall market. A beta higher than 1 indicates more volatility than the market, while a beta lower than 1 suggests less volatility. A fund with a high beta may have performed well in a rising market but could struggle in a downturn. Understanding the fund’s beta allows investors to see how much of its performance is tied to broader market movements rather than manager skill.
The Sharpe ratio offers another useful perspective by measuring the return generated per unit of risk. A higher Sharpe ratio indicates better risk-adjusted returns. This is particularly useful for comparing funds within the same asset class or market sector. However, even a high Sharpe ratio needs to be viewed in context, as certain market conditions can inflate risk-adjusted returns for a short time.
Consistency in performance across various time frames and market environments is another critical factor. If a fund's performance is volatile or shows sharp swings, it may signal that the manager is taking excessive risk or that the strategy is heavily dependent on short-term trends. Investors should seek funds with a track record of delivering steady returns, even if they aren't the highest performers in any given year. Stability is often a sign of a disciplined and repeatable investment process.
REPEATABLE STRATEGY VS MARKET ANOMALIES
A key challenge for investors is distinguishing between a fund that follows a repeatable, sound strategy and one that has simply benefited from temporary market anomalies. A repeatable strategy is one that can be consistently applied across different market conditions. These strategies tend to rely on factors like solid stock selection, risk management and diversification, rather than speculative bets or niche sector plays.
Funds with a repeatable strategy usually have a clearly defined investment philosophy. They often have long-term objectives, avoiding the temptation to chase short-term market trends or sector-specific bubbles. For example, a fund that focuses on long-term value investing, with disciplined analysis and a focus on fundamentals, is more likely to demonstrate performance persistence than one that relies on timing the market or riding sector momentum.
Conversely, funds that have shown strong performance due to market anomalies – such as a boom in a particular sector or an unusual market condition – may not sustain their returns once the anomaly passes. A technology fund, for instance, may perform well during a period of rapid sector growth, but if the sector cools or faces regulatory challenges, its performance could suffer. Investors need to be cautious about funds that have had concentrated exposure to specific trends, as these may not be repeatable in the future.
ACADEMIC AND PRACTICAL PERSPECTIVES ON PERFORMANCE PERSISTENCE
Research on performance persistence reveals that while short-term persistence may be observed, long-term persistence is rare. A seminal study by Mark Carhart (1997) found that much of the persistence in mutual fund performance could be explained by factors such as market risk, size and momentum, rather than by skill. Carhart’s findings suggested that funds showing exceptional performance often benefited from temporary market conditions or anomalies, rather than possessing a sustainable edge.
Further research supports the view that while some funds may exhibit short-term persistence, over the long term, performance tends to revert to the mean. This is especially true for actively managed funds, where high fees can further erode returns over time, making it difficult for even the most skilled managers to consistently outperform.
Practical perspectives from professional investors and fund managers also highlight that performance persistence, when it occurs, is often the result of disciplined risk management, a clear investment philosophy and consistent execution. Rather than relying solely on past returns, investors should look for managers who have demonstrated success in different market environments and who maintain a transparent, repeatable process.
HOW TO ASSESS FUTURE PERFORMANCE POTENTIAL
While no one can predict future performance with certainty, there are practical ways for investors to evaluate a fund's potential for continued success. The first is to assess the fund manager’s track record. A manager with a long history of successfully navigating different market cycles may have a higher likelihood of continuing to deliver strong results.
Next, consider the investment strategy. A fund built on a clear, repeatable approach, such as value investing or growth at a reasonable price, is more likely to generate sustainable returns. Avoid funds that rely heavily on market timing or speculative bets, as these strategies often struggle in unpredictable markets.
Risk management is also crucial. Funds that employ robust risk controls and maintain diversified portfolios are better positioned to handle market volatility. Lastly, consider the impact of fees on performance. High fees can eat into returns, particularly in actively managed funds, making it harder to consistently outperform.
While the concept of performance persistence may be appealing, the reality is that past performance does not reliably predict future success. Investors should approach historical returns with caution, focusing instead on understanding the underlying strategy, risk management and overall fund structure. By taking a comprehensive and disciplined approach to fund selection, investors can improve their chances of identifying funds with the potential for long-term success, while mitigating the risks of chasing past returns.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.