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Smart investing
Why today's winners are tomorrow's losers
4 May 2007
Robin Bowerman

You can almost hear investors around the world grinding their teeth. They have decided to invest, picked last-year’s top-performing fund only to see it plumb the depths of the performance tables for the next year or two.

There is a good reason if that sounds a familiar story. A new research study by leading independent research group Morningstar looked at 10-years of Australian sharemarket funds and found that investors expecting a repeat of last year’s great result from a fund will generally be disappointed.

Take 2000, when the top five shares funds posted an average return of 35%. The following year the same five funds delivered an average return of 9.2%. According to Morningstar the top fund in 2000 achieved a return of 47.8% for that year but the next year underperformed the index and produced a return of only 7.6% and then continued to underperform the index through to 2006, making it the bottom-performing fund. Thirty one percent of funds in the top five in 2000 failed to match the index the following year, some by a large margin.

The 10-year study showed that only 22% of funds that were in the top five in any one year repeated the result the following year. More revealing still is that a portfolio of the top five performing funds – equally weighted – in each year underperformed the index over the year to June 30 2006.

And then there is the issue of risk measured by a fund’s volatility. Morningstar gave the example of the Phillips Special Situations Fund which it says has volatility twice that of the typical share fund and appears regularly at either the top or bottom of the study.

The study also highlights another serious issue for investors – the simple issue of a fund’s long-term survival. Investors – particularly those saving for retirement have long time horizons – but even good performance is no guarantee of survival. Almost 30% of the funds analysed in the Morningstar study do not exist today while 18.8% of the funds that appeared among the top performers in any year were among those terminated.

Morningstar’s study – which was first done in 2003 – reminds us of some basic principles of investing:
Focus on the long-term objectives rather than chase past winners
Understand which factors have driven a fund’s returns
Understand the risks inherent in a particular investment
Build diversified portfolios

To that you can add another important factor that investors can control – costs. Keep them as low as possible.

Morningstar’s research study boils down to one powerful point – past performance is a poor guide to picking next year’s winners.