Why You Shouldn’t Shun Poor Performing Funds

Investment portfolios should be greater than the sum of their parts. So the blend of assets classes and funds are designed with the aim of providing better long term returns than a bunch of disparate funds. That’s why we encourage investors to focus on portfolios as a whole.

We’re sometimes asked, however, why we invest in funds that may not have performed particularly well recently or have low fund ratings. After all, wouldn’t you be better offer sticking to those that have topped the performance charts or are 5 star-rated rather than 1 or 2? Not necessarily, as we’ll explain.

The Past Has Passed

You can’t invest in past performance. That might sound obvious, but many investors still base their investment decisions solely on how things have previously performed. So they’ll sell the laggard funds in their portfolios and buy the biggest gainers assuming a repeat of returns in the future. That’s rarely the case though. Sometimes things with the best or worst returns from one period can end up at the opposite end of the performance charts during the next.

That doesn’t mean you should seek out the lowest-returning funds expecting them to sling shot to the top of the pile. It does mean, however, we think you should invest in a range of different things and avoid selling funds automatically at the first sign of poor performance – you never know what will deliver the best returns from one period to the next.

Stage Performance

One major reason why fund performance can be so variable is that markets, like economies, go in cycles. Sometimes they’re going up, other times they’re going down. At different parts of the cycle, some investment areas and fund styles will work well, and others won’t, as shown in the graphic below.

Stages of the cycle can last several years, giving the illusion that funds benefitting during a given period have become permanent winners. If you only invest in those though, your portfolio will likely be full of funds investing similarly to each other. When the cycle turns, they could all go through a rough patch together, landing your portfolio in hot water.

Why not switch in and out of funds when a new stage of the cycle begins though? In theory this sounds sensible, but in practice it’s extremely difficult to do. It requires correctly and consistently predicting market cycles and their stages, which can be very erratic. They can vary in length enormously, there’s nothing to announce the start of a new stage, plus they don’t always go in sequential order.

Fund Ratings: Overrated?

Past performance aside, many investors heavily rely on independent fund research agencies such as Morningstar and Trustnet to select funds. Most of them have a ratings system – such as assigning a number of stars or crowns out of five. Some investors, individual and professional alike, will only invest in four or five-star/crown funds, but we think this is a mistake.

To explain why, it’s important to understand how these ratings work. While some may think they’re an assessment of a fund’s quality or a prediction of future performance, they’re usually nothing of the sort. In most cases they’re based on nothing more than past risk-adjusted returns, often over no longer than three years.

Going back to market cycles, this means funds whose style has benefitted from the current stage will usually receive a higher rating than funds whose style usually works best during others. That’s why ‘growth’-style funds are in general currently rated more highly than ‘value’ ones, as the market has favoured the former over the latter in recent years.

So really all the ratings tell you is how well a fund has performed in recent market conditions, and nothing about how the rating agency believes it’ll perform in the future. That’s why we think they’re generally a weak guide to judging funds, and why we don’t pay any attention to them.

Our Approach

Our portfolios include exposure to lots of different fund styles within our portfolios. Some of them tend to work well in rapidly rising markets, while others will typically benefit when markets slow, wobble or recover. This means at any given time, alongside those with strong returns and high star or crown ratings, some will show weaker returns or low ratings. That’s true diversification though, and ensures your funds aren’t all pointing in the same direction, which could be down as well as up.

Of course we don’t seek out funds that have performed poorly for the sake of it. All our funds are thoroughly researched and only those we believe will deliver strong long-term returns are selected. Just because something’s not done well recently though doesn’t mean we won’t invest in it, nor sell it if it’s already in the portfolio. After all, today’s one-star fund could become tomorrow’s five-star.