By far the most common disclaimer that mutual fund managers give to potential clients is that past performance is no guarantee of future returns. Despite this warning, the sales pitches of fund managers tends to suggest otherwise. They tend to tout their years of historically good returns, almost guarantee that their fund beats risk-free investments in the long-term and make it seem like a negative return is beyond the realms of possibility.

I can understand the situation. The investment business involves cut-throat competition. It is relatively easy for clients to move their monies elsewhere and therefore a large part of fund managers’ efforts is dedicated to keeping their clients and attracting new ones. Another reason why fund managers tend to almost guarantee returns is because of the behaviour of investors. Investors love to chase recent performance. If one fund returned 6% one year and another fund returned 14% in the same year, the investors are likely to pull out funds from the first fund and invest it in the other fund.

There is a US rating agency known as Morningstar which rates fund managers based on their returns. Each year fund managers are rated from 1 to 5 stars based on their performance for the period under review. Analysis by the American Institute of Individual Investors show that when fund managers were upgraded from 3 to 4 stars or 4 to 5 stars, net money inflows into the fund was between $14 million and $331 million. However, when a fund was downgraded from 3 to 2 stars or 2 to 1 star, they saw net money outflows of between $65 million and $257 million. This is an indication that people were moving their monies out of low-rated funds and into high-rated funds. This seems like a rational thing to do. However, a study reported on by ETF.com found out that from 1992 – 2009, 39% of the 5 star funds outperformed their benchmark while 46% of 1 star funds achieved that result. The the study showed that 5 star funds actually had the most difficulty maintaining their ratings because of poor returns going forward. Now this does not mean that one should invest in low rated funds. But it does mean that one should not go shopping for performance. Consistency is important.

There are many more studies that will show you that you gain most by keeping monies still over a long period of time but I would like to explain this phenomenon intuitively. The higher the price one pays for an investment, all things being equal, the lower the return one should expect from the investment. For example, if you bought the stock of a company at GH¢1.00 you should expect that no matter what happens going forward, you cannot mathematically gain more on your investment than someone who bought the share at a lower price, say GH¢0.50 (as long as you both hold the stock).

It is the same with fund managers. The people who will benefit most from a fund manager who has delivered a high return are those who were already invested in the fund. Those who come after are actually buying into the fund at the time when the fund is most expensive. The same is true for those who sell out of a fund when it is most cheap and therefore miss out on the rally when the fund’s return goes up.

I have never gone performance shopping among mutual funds so I cannot say this is a mistake I have made. For risk management purposes, I allocate my funds among different mutual funds and make scheduled contributions to them. This allows me not to miss out on top performers while not panicking out of underperformers who could later prove to be stars.

My post is not to suggest that one should never leave a fund manager for another one. In fact, the competition for customers’ funds is good for driving fees and commissions down. There are good reasons to leave a fund manager but it should not include chasing another manager who has just had a stellar performance.

Thanks for reading Part 2 of the Investing Mistakes series. You can read Part 1 here.