7 December 14

Investing through the rear-view mirror

Driving experts warn about the poor driving technique of concentrating excessively on what a driver can see in the rear-view mirror rather than focussing enough on looking through the windscreen at what’s well ahead on the road.

Investors, of course, can fall into a similar rear-vision trap of focussing excessively on investment returns from the past, and hoping that past investment winners will repeat their success over the next 12 months or so.

This rear-vision investing – often termed “chasing past winners” or “performance chasing” – is fraught with hazards.

A recent Smart Investing piece, The annual review that keeps on giving, spoke about the “inevitable hit parades” of the performance of the main investment asset classes that appear around the end of each calendar and financial year.

The key message was that while such lists may be interesting, the comparisons can tempt many investors to fall into the trap of chasing past winners – despite the random nature of markets that drives them up and down.

Performance chasing applies to investment asset classes as well as particular investments and managed funds, for instance. It commonly involves switching to managed share funds that outperformed their peers in the past over the short and/or longer terms.

As 2014 accelerates rapidly to a close – to risk labouring the motoring analogy – it is worthwhile revisiting research published by Vanguard analysts in the US earlier this year – that does some number-crunching on the potential cost of rear-vision investing.

Their paper, Quantifying the impact of chasing fund performance, examined whether a buy-and-hold strategy or a strategy of chasing past winners was likely to produce the highest returns for investors, given certain assumptions.

And their unambiguous conclusion: A carefully-constructed, buy-and hold strategy – based on the performance of US equity funds over the 10 years to December 2013 – was clearly the “superior approach”.

The buy-and-hold strategy involved carefully selecting a share fund in the first place and then maintaining a disciplined, long-term perspective despite short-term fluctuations in a fund’s performance.

What made the superior performance of the buy-and-hold strategy even more compelling is that tax and transaction costs excluded from the calculations.

The analysts focussed for their primary analysis on the universe of active US equity managed funds, covering nine styles including large growth and value funds, mid-cap growth and mid-cap value funds, and small growth and small value funds – together with funds that blended different investment styles.

After filtering out funds that remained in existence for under three calendar years, the study focused on a sample of 3568 funds. Various trading “rules” were set for the analysis.

For the performance-chasing strategy, the trading “rules” were: initial investments were made in any fund that produced above-median annualised returns between 2004 and 2006. Funds that then produced below-median, three-year annualised returns were then sold and the proceeds immediately reinvested with the top-20 performing funds over the prior three-year period.

For the buy-and-hold strategy, the trading rules were: Initially investing in any fund, selling only if the fund is discontinued. And then the analysts allowed for reinvesting in the median-performing equity fund for the particular investment style.

In short, the researchers confirmed that maintaining a disciplined, long-term perspective to investing – despite fluctuations in performance – is a simpler and more effective approach than chasing past performance.

 

Written by Robin Bowerman, Principal, Market Strategy and Communications at Vanguard Australia. 

 

This material has been reprinted with the permission of Vanguard Investments Australia Ltd

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