Is it possible to choose investment funds using past performance data?

Standard & Poors, a major fund rating agency has recently carried out research into tthe extent to which funds which have performed well in the past go on to doing so in the future.

The issue here is not whether active funds are capable of doing well. Some, undoubtedly are capable of generating good returns. The problem, as shown by the Standard & Poors, is that very few of the good performers go on to repeat their previous performance.

So what does this mean to private investors? For one thing it indicates that trying to build your portfolio using actively managed funds, no matter how much time and effort you or your adviser puts into choosing them, is likely to be a complete fools errand. You are likely to pay more for something (out performance) that you are very unlikely to get. In addition, if you are regularly swapping one fund for another on the strength of the poor performance of funds that you already hold in favour of ones that have done better over the same period, you will just be incurring extra costs and most probably spending time out of the market. This is one of the main reasons why large numbers of private investors substantially under perform the markets in which they invest.

The answer is to avoid the uncertainty and extra costs caused by active fund manager selection and instead to build the portfolio through index trackers and passive funds. This is, of course, the second step in the construction of a portfolio. The first is to ensure that you have adopted the correct asset allocation for your needs.

Chris Wicks CFPI help you achieve your lifetime goals for reasons that are important to you

Two Professors of Finance discuss the future of the markets

In this clip Dean of University of Chicago Booth School of Business Edward Snyder and Professor Eugene Fama discuss common questions on the efficient markets hypothesis, the credit crisis, and the business of business schools.

The topics discussed are core to our understanding of how the markets work and therefore the way in which we construct portfolios. The clips lasts just under an hour but it is time well spent for anyone interested in hearing an academic rather than a marketing hype view of how the markets work.






Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you

Why Active Investing is a Negative Sum Game

In this article well known academics Eugene Fama and Kenneth French reflect on Nobel Laureate William F Sharpe's 1991 article on the arithmetic of active fund management. This has already been discussed on this blog and you can see a copy of that article here

Cutting through the slightly complex jargon that is used by Fama and French,the essence of what they are saying is that the combined portfolios all active investors have the same weighting in shares as the market as a whole. This means that the combined portfolios can only perform the same as the market, less their costs. It also means that the only way in which an active investor can outperform the market is to do so at the expense of other active investors.

In contrast, passive investors also all hold the same weighting in shares as the market as a whole. This means that their portfolios should perform the same as the market, less their costs. However, as their costs are less than those of active investors, passive investors as a group must outperform active investors.

This article does not seek to deny that some active investors do outperform the market. It is just that their gains have been made at the expense of other equally clever active investors. Other research has shown that winners tend not to repeat and that on the whole, they do not tend to remain winners for very long.

When considering whether to invest actively or passively you have to answer the question 'Are you feeling lucky?' For active investors the answer must be 'Yes' - in the face of the evidence. For passive investors the answer is 'No - but at least I will be assured of returns that essentially replicate the market less my costs which are substantially less than for active portfolios'.

From a financial planning point of view, investing should not be seen as a game. Investments are not an end in themselves. Instead they are the means by which individuals fund for the serious financial goals, which they need to achieve in order to lead the future lifestyles that they desire. Speculation on which fund manager is likely to provide better returns than another, in the face of evidence that this is likely to be an unsuccessful strategy, has no place in this process.

Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you

Stock Picking v Index Investing

I have just found this extremely interesting video link which shows Professor Kenneth French talking about Stock Picking and Index Investing. He explains, far better than I ever could, how stock picking is essentially a fools errand ... but a very necessary one which enables those of us with more sense to take a cheap ride on the increased market efficiency which their zero sum strategies create. He also makes some very interesting comments about Hedge Funds.

Hidden Costs of Investment

Hidden Costs of Investment

Passives and Index Trackers are vastly cheaper than Active Funds. It is not just a question of the Total Expense Ratios but also the cost of turnover.

Take the UK All Companies Sector as an example. Most actively managed funds have an Annual Management Charge of 1.5% pa. In addition they have other expenses declared of typically another 0.1% to 0.2% pa. Let’s be nice to them and say, on average, the combination known as the Total Expense Ratio (TER) amounts to say 1.6% pa.

Compare this with say Fidelity Money Builder UK Index Tracker with an AMC of 0.1% and a total TER 0.28% pa. Before even considering portfolio turnover costs the average Actively Managed fund has to deliver a further 1.3% or so per annum without taking any more risk than the index as a whole in order to simply match a tracker. Of course, there is no point in paying extra simply to break even with what you would have got if you just tracked the index.

Let’s now look at Portfolio Turnover Rates (PTR). These describe the proportion of the fund that has been turned over due to sales and purchases and is calculated according to a formula prescribed by the FSA. It is now a requirement for these to be published for UK unit trusts and OEICs within the Simplified Prospectus. You still have to hunt around for these figures as they are often quoted separately to other cost data. I am collating details of these prospectuses and will publish links in due course.

In the FSA Occasional Paper on the Cost of Retail Investments http://www.fsa.gov.uk/pubs/occpapers/OP06.pdf and, in particular on page 28, the average cost of a deal in a UK fund has been estimated at 180 basis points (1.8% to you and me). To find the cost of turnover you have to multiply the above cost by the PTR.

If you take the average PTR of an Active UK fund of 70%-90% (page 47 of the FSA paper) you end up with costs in addition to the TER of between 1.26% and 1.62%. If you take the Fidelity Special Situations Fund PTR of 137% you get an overall portfolio turnover cost of 2.46%. Quite a few active funds have PTRs of over 200%.

To get the total annual cost you have to add the PTR cost to the TER. This means that the actual annual cost of the average Active UK Fund amounts to between 2.86% and 3.22%. In the case of the Fidelity Special situations Fund you get total annual fund costs of 3.96% pa.

Contrast this with some trackers. The F&C FT All Share Index Tracker has a PTR of 0% and a TER of 0.39% and the Fidelity Money Builder with a TER of 0.28% and a PTR of -2.3%. These mean that the average active fund has to outperform them without taking any more risk by up to 2.94% per annum.

The sad truth is that most active funds can’t even achieve index levels of returns let alone beat them. So, why would you pay extra for that?