Crack down in how performance reported

One of the great debates in the investment world is what value does past performance have in predicting future returns?

Wednesday, March 26th 2003, 6:52AM

Recently a report came out of the United Kingdom which said that past performance can be a useful indicator of future performance. Well that's what the headlines screamed. But once you dig down into the report it becomes clear that this is a highly qualified statement.

It said that "performance broadly persisted in UK equity based unit trusts between 1981 and 2001." This was particular so for two sub-sets within this group.

"These numbers do not show that picking last year’s winner guarantees you out-performance next year. But they do suggest that, on average, past performance relative to peer group has a tendency to carry forward into the future, for both strong and weak performance," Investment Management Association chief executive Richard Saunders says.

He went on to suggest that the Financial Services Authority (which regulates managed funds in the UK) should introduce standards for presenting past performance.

However, in Australia Tim Brailsford, who heads the Funds Management Research Centre in Queensland, says that past performance isn't of much use and he says that the country's regulators are going to crack down on how historical numbers are used to promote funds.

Like the people in the UK Brailsford qualifies his comments.

For instance a fund which sits in the bottom 10 to 20% of the league tables is likely to find it very difficult to get out of that position. One of the reasons is that once a fund has a bad name it struggles to raise new money and grow.

"If you're fund is in the bottom 10-20% there is a reasonable probability that performance will repeat itself."

His advice here is to get out.

Also funds which sit in the middle of the table often tend to stay in that position too.

He says not a lot of research is done on the middle funds, but the evidence to date shows that "average funds remain average."

From an investor's point of view they are not much good as the middle of the table funds are just giving the same returns as the market and this level of return can be achieved at lower cost by using index funds.

Brailsford says looking at straight performance numbers isn't a sensible thing to do. Rather investors need to look at return on a risk adjusted basis, that is how much risk was taken on to achieve the return.

He says that two funds could have the same return over a set period of time and one may have got there by providing consistent, year-on-year returns and the other got there with lots of variability (ups and downs) in its returns.

Understanding how returns are generated is necessary to know what sort of ride you can expect along the way.

Also with the fund which has the less consistent set of returns there is a chance you could be getting in at either a peak or a trough.

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