Chasing Past Performance: Yesterday’s Winners May Not Be Tomorrow’s

This is a standard disclaimer put out by mutual fund companies to dissuade investors from chasing past performers. 

Behavioural economists widely consider ‘performance chasing’ a major investing mistake. This practice involves investors choosing mutual funds, hedge funds, or other actively managed investments based on a fund manager’s past performance, assuming that previous success will continue. This is known as recency bias—the tendency to give undue weight to recent outcomes while ignoring long-term data. 

Performance chasing is a common trap, often driven by the fear of missing out (FOMO). We see friends making money in hot stocks/funds, or Bitcoin, and rush to invest, only to experience the inevitable downturns that follow such investment fads. At that point, fear of losses takes over, leading to selling at a low. This ‘buy high, sell low’ behaviour is the opposite of sound investing.

To illustrate the impact of chasing past performance, let’s look at some real data. I gathered the annual returns of large-cap equity mutual funds with at least 10 years of performance history. Then, I calculated the average performance over the past 3 years. The strategy assumes that its strong performance will continue by investing in the top-performing fund. I will keep shifting my investment based on the previous 3 years’ average performance. 

In the large-cap category, the top performer in 2016 was the Quant Focused Fund(G), with an average return of 29.3%. Let’s assume we began investing in this fund at the start of 2017. The table below outlines this hypothetical investment journey. The returns rank reflects the fund’s relative performance within the universe of large-cap equity funds for each year. 

As shown, none of the funds consistently delivered returns that outperformed the broader universe. The invested fund ranked among the top 5 performers only once during this period.

Key Aspects of Chasing Fund Manager Performance:

• Mean reversion is the concept that over time, investment returns tend to move back toward the average or mean. In the case of fund managers, periods of high outperformance are often followed by periods of average or below-average returns. Chasing performance often leads investors to buy into funds that have already peaked and are more likely to revert to lower returns, meaning that investors who enter late may not see the same level of gains.
  • For instance, while Quant Focused Fund(G) generated an average return of 29.3% between 2014-2016, its average return over the next 3 years was just 10.1%. 

• Style drift occurs when a manager shifts their investment strategy to chase trends or adapt to changing market conditions, which can lead to unexpected results or increased risk. 
  • A fund manager who has consistently performed well might have done so due to specific market conditions favoring their investment style (e.g., growth vs. value, small-cap vs. large-cap). If the market environment changes, that style might underperform, and so will the fund.

• Market cycles play a role here as well. A fund that performed well in a bull market might underperform in a bear market, especially if the fund manager’s strategy is not suited to different market conditions.
  • Investors who chase performance often enter a fund after it has already experienced significant gains, missing the period of rapid growth. By the time they invest, the fund might experience a correction or slowdown, leading to lower-than-expected returns. 

Alternatives to Chasing Performance:

• Understand your risk profile: Consider factors such as investment goals, time horizon, current financial situation and emotional response to volatility to assess your risk tolerance.

• Align your portfolio with your investment theme: Consider the portfolio’s theme and ensure it aligns with your goals instead of investing in a portfolio because it has the highest returns.

• Analyze volatility and risk-adjusted returns: Based on your risk profile, you should study the volatility and risk-adjusted returns of the portfolio. Volatility measures how much the price of a portfolio fluctuates. Risk-adjusted return measures how much return you get compared to the amount of risk you take.

• Factor in costs and transparency: Before choosing a portfolio, understand the cost structure and level of transparency. Hidden fees can significantly eat into your returns.

Conclusion

Chasing past performance is a common but flawed investment strategy that often leads to disappointment. As illustrated in the data, even top-performing funds can struggle to maintain their winning streak, with periods of strong returns often followed by average or below-average performance. The concept of mean reversion, changes in market conditions, and style drift all contribute to the inconsistency of fund performance over time. Instead of chasing the highest recent returns, investors should focus on aligning their investments with their long-term goals, risk tolerance, and an understanding of volatility and costs. Building a diversified portfolio and taking a disciplined approach will ultimately yield better results than reacting to short-term performance trends.

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