Pay less attention to historical returns

Sonnie Bailey

7 February 2020

“Past performance is no indication of future performance.”

If you’ve looked at any investment product with proper disclosure, you’d be familiar with this refrain.

It’s a statement that’s required by law. It’s easy to think of it as compliance-speak.

But it’s true.

You can’t draw firm conclusions about the future returns of an investment based on its historical performance.

The best you can do is draw general, extremely high-level conclusions.

For example:

That investment classes like shares will tend to be more volatile than investments like bonds and shares over the short-term but are likely to generate higher returns over the long-run.

That you’ll tend to get a small return premium for investing in assets that can’t easily be turned into cash in the short-run.

There is a general relationship between risk and return (even if it’s not a linear relationship: some investments can be lemons from the start, and can involve high risk and have little to no potential for good returns. Like investing in anything that is associated with Donald Trump that is above board – I’m joking, because those investments don’t exist).

Monthly performance means very little. Five-year performance figures, too.

It bugs me that a certain investment platform sends monthly emails talking about their best performing funds for the month. My hope and expectation is that most people reading those emails understand that focusing on monthly returns is focusing on noise.

Anyway. One of the things that gets my goat is that people will often adhere to this perspective – that you can’t draw conclusions about future returns from past performance, only to a point.

Of course, you can’t look at the last 12 months! And looking at the past 3 years is silly.

But somehow, when you start to get to 5 years… well, those figures start to look credible. If a fund has been around for 10 years, there must be some truth to that!

And looking at returns since “inception” of a fund that’s been around. Surely you can trust that.

Well…. no.

Think about the last five years, for instance. We’ve been a pretty homogenous, bull market. We’ve seen fairly steady growth in New Zealand and around the world. We’ve experienced a few jitters here and there. But nothing resembling a market cycle.

So how can we draw conclusions about how a fund will perform in a different environment?

With funds that have returns of 10 years or more, don’t forget the survivorship bias. They have been around for this long because they’ve generated reasonable returns. The funds that haven’t (including, in many cases, other funds managed by the same investment manager) have been closed down. As soon as this fund starts posting performance that can’t attract investors, this fund will close down or change substantially as well.

Even well-established funds can change.

Consider Berkshire Hathaway, the legendary investment management firm co-founded by Warren Buffett and Charlie Munger. What will happen when Buffett (89 years’ old) and Munger (aged 96) move on?

Will they be able to pick managers who can perform as well as they have?

Consider this article from McLean Asset Management, titled “Occam’s razor: One of the most successful active managers of all time shows why active management doesn’t work”.

The article starts off by talking about Peter Lynch of the Fidelity Magellan fund:

“There’s little question that Lynch had “it.” You can slice and dice the data any which way you want, but it’s pretty clear he was able to beat the market on a risk-adjusted basis. Often he is pointed to as “proof” that active management works.”

Lynch, like Buffett and Munger, is something of a legend.

However, as the article explains: “he’s the exception that proves that it doesn’t work”.

The article talks about Peter Lynch’s successors and concludes:

“We can learn all sorts of lessons from Lynch, but one is particularly applicable to typical investors: picking winners is hard.

Even Lynch, who was a winner himself, couldn’t do it. Or at least his pick(s) weren’t good enough for us to be able to separate their skill from the random noise of the market.

Picking winners is more than just finding a fund with a five-star rating from Morningstar and pretty good three- and five-year returns. You have to find someone who can out-predict the entirety of the market for years at a time. They need to be able to see the connections that everyone else doesn’t, and then figure out what they will mean for security prices.

They need to be able to predict the future. That’s a pretty big ask.

And even with all of the information available to him, and the skill to do it himself, Lynch couldn’t identify anyone else who could follow in his footsteps.”

In other words: history suggests that Buffett and Munger won’t find successors who will perform as well as them.

Maybe I’ll be wrong. Maybe I’ll be right. The truth is, unless you have a crystal ball, you can’t know for sure.

The methodology of the fund is what’s important.

This is another reason why I think investing in index-based funds is a good bet.

You know what you’re investing in, and the methodology is going to stay consistent over time, regardless of market cycles, and regardless of the team managing the fund.

On top of that, you get to save unnecessary fees.

Will you get the best return? Probably not.

But can you predict the manager that what will get the best return?

That’s a question about the future, not the past. And if Peter Lynch couldn’t do it, good luck to you.

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