Friday, October 26, 2007

How hot performance can deliver bad results

This from Smart Investing by Robin Bowerman 26/10/07
Performance tables make for interesting reading but some new research has found they can mislead as much as inform investors.

The underlying flaw in performance tables - be they over one month, one year or seven years - is that the return numbers will not reflect the return that most investors actually receive.

Investors understand that the time period published in a performance table is rarely going to line up exactly with their investment time period so the total return number is only an approximate guide.

But research by the leading research company Morningstar raises more fundamental questions about how useful - or misleading - total return numbers can be. Morningstar's managing director, Don Phillips, was in Australia recently for the Australian operation's inaugural investment conference. His presentation looked at why total returns may not equal investor returns.

The normal performance measures we are used to seeing published in specialist magazines, websites and newspapers are time-weighted calculations and assume that an investor buys and holds for the entire period typically with no additional investment.

Morningstar in the US have developed a methodology for calculating an "investor return" which is a money-weighted calculation that accounts for aggregate monthly purchases and sales by all of a fund's investors.

The impact can be dramatic: Morningstar used an example of a US fund that had a healthy 10-year total return of 15.05%. When the 10-year investor return was calculated it was -1.46%. How can the numbers be so wildly different? The answer lies in the nature of the fund's performance. It had three years of spectacular returns followed by three years of significant losses. So investors followed the performance with most of the money turning up around the end of the strong performance period - just in time for it all turn sour.

So the nature of a fund's performance is probably more important than most investor's realise in terms of capturing their fair share of the return. Morningstar looked at another fund with a similar 10-year total return of 15.03%. But its investor return was 14.75% - investors got much closer to capturing the fund's headline return number.

Phillips says the difference is in the nature of both the performance profile - it was a steady rather than spectacular performer - and because of that investors had invested steadily and the fund's size had grown steadily and in a more orderly manner. Most importantly investors stayed put even when there were a couple of years of negative returns.

The big hit for investors in the first fund was that they invested after the best performance had been achieved and then sold out once the pain of three years of losses got too much to stand. So most investors had a dramatically different experience to what the healthy 10-year total return numbers would suggest. Morningstar's research has concentrated on the US market but an initial look at the Australian market, Phillips says, suggests a similar pattern of behaviour and return result.

Another interesting point out of the research was that the style of fund made a difference to investor's real world result. The gap between total return and investor returns was widest among specific sector funds - US equity funds for example had a 10-year total return average of 10.42% compared with an investor return of 7.64%.
In contrast balanced funds on Morningstar's database delivered a slightly lower total return of 9.12% over 10 years in total return numbers but investors enjoy a much higher success rate of capturing the return - investor returns were 8.93%.

Phillips says that diversification leads to better results for investors. Why? Perhaps because the diversified funds do not have the meteoric years that attracts a flood of hot new money or crushing down years when investors capitulate and sell out crystallising big losses.

Supporting that argument is the Morningstar work that shows that volatility hurts investor's chances of capturing a fund's full return. Low volatility funds had a success ratio of 98% in terms of investor's receiving the total return compared to only 62% for the high volatility funds in the research study.

Hopefully Morningstar will extend this work to the Australian fund universe because clearly there are valuable lessons investors and advisers may be able to learn from it.
We have all seen the warnings about past performance not being a guide to future returns but what Morningstar's work offers is an insight beyond the headline return numbers that gives a better indication of whether a fund did a good job for its investors.

But perhaps the most powerful message out of Morningstar's research is for investors not to chase the latest hot performer but rather take a disciplined, long-term approach to their asset allocation and avoid the dangers of trying to time market moves.