Unmasking mirage of past performance in investment

A fund's success isn't solely attributed to historical returns, but rather a combination of skilled management, investment philosophy, and market conditions. Overreliance on recent performance can lead to pitfalls, as extreme past success often gives way to underperformance. An agile approach, coupled with the understanding of mean reversion, helps in making more informed investment decisions

When making an investment decision we check for various parameters to shortlist out of the various options. Variables like time horizon and risk tolerance are individual dependent, while the asset type, its risk profile and performance are inherent to the investment. For instance, considering a fund we would look at the fund objective, the fund house or manager pedigree (in sticking to the objective), the prospects of the fund and then various other technical parameters like alpha (return over benchmark), beta (sensitivity vs benchmark), Treynor’s ratio (additional return for incremental risk), etc.

However, while checking for these, we invariably end up looking at the performance of the fund i.e., past performance of the fund vis-à-vis the benchmark and/or peer group. This one metric perhaps overshadows or overwhelmingly consumes our analysis and this is not completely wrong. When we’re trying to invest in a fund, we need to know how that fund’s strategy has worked in the past, etc. is fair and valid.

Even as the very disclaimer states explicitly, ‘past performance is not indicative of future returns’, we tend to base our analysis around it. We might not admit it, but it plays an important role in our decision making. How much ever would we deny, we tend to be drawn towards the most recent performance as a critical criterion for our investment selection.

While it’s not completely wrong to check for the past performance, it’s better to subject it further examination, particularly if it’s an active management fund. This includes on how much of the performance is attributed to skill of the fund manager? Is it the fund philosophy or the investment style that worked wonders? Is it due to purely from the market momentum and that random luck of being invested there at that point of time? These are the questions to be asked when comparing the past performance.

We need to accept that not all funds or their strategies work in all market environments. So, if that’s the case then how do we separate the wheat from the chaff. History shows that an extreme strong performance is not only difficult to sustain but leads to relative underperformance into the future. This is because as the rally builds in the price, the possibility to continue further is limited and can’t be extended. Also, as markets heat up, the possibility of reversal in the sentiment is high and hence market corrections. Hence, it’s futile to extrapolate the past performance into future returns.

As the fund size bulges, the initial ability to remain agile is lost and allocations could be spilled into non-core areas of the fund or its philosophy which results in underperformance. Herd mentality leads to further complications as investors try to chase these performers and possibly will have to sit out of the market movement as the fund cycle might deviate. This is why we see continuous fresh inflows into a fund managed by a successful manager or to market segment/sector that has already run up.

And due to better past performance, there’s a high probability of attracting fresh flows into the fund which could hinder the future management of the fund. This is due to the outcome bias exhibited by the investors. Investors believe that a fund or asset’s good performance is attributed to its inherent nature of the asset or fund. It misleads investors to this that the investment is good and hence the better returns, ignoring the risks associated with it. Another important feature of any asset market is the reversion to mean. Prices don’t constantly only go up, but they tend to correct in between, which is known as mean reversion. As the prices go up creating bullishness among investors, too much froth is built up, leading to price corrections. This is when investors comprehend that the fundamentals don’t support the price or would’ve to stay invested for a very long duration to realize the last seen near term high returns. This could happen with funds as well and so could remain underperformance territory with respect to peers after a stellar performance.

Of course, for trend followers this is a good indicator but those investors exploring this style should be very nimble in identifying the trend early on and exiting at right levels to stay in the right side of the trade.

(The author is co-founder of “Wealocity”, a wealth management firm and could be reached at [email protected])