Reality Check: Fund performance is more about statistics than skill

    26 November 2016

    As the year-end approaches, many investors will look back at their stock-market funds to see how they have performed. Typically, most will choose to sell the fund that has done worst, concluding that the fund manager is doing a poor job.

    So if Fund A is up 12 per cent, the FTSE100 is up 10 per cent and Fund C is up only 8 per cent, you will most likely sell Fund C — and probably put the cash into Fund A. This is, however, completely and utterly the wrong thing to do. You are confusing statistics with skill. Let me explain.

    The average height of a British man is five feet and nine inches. Obviously, some are taller and some shorter, but the vast majority are within a few inches of the average. There are outliers, over six feet or under five feet six inches, but they’re rare. The variance in heights is called a ‘normal distribution’ — or if you’re a bit older, you may remember it in maths as a Bell Curve.

    Many things are distributed this way: blood pressure; test scores; even income. But most importantly for readers of this column, so also are the returns from the thousands of actively managed stock-market funds. Most UK large-cap funds will return a little less than the FTSE100 index because active fund managers charge high fees that reduce the return for investors. A few will do better than the FTSE100 in one year and a few will do significantly worse. Fund returns are normally distributed. Which means relative performance is mainly a matter of statistics, rather than skill.

    Skill is the ability consistently to buy shares that will subsequently go up and to sell shares before they go down. But such skill is demonstrated conclusively only over many years of outperformance. Data from Vanguard and Morningstar show that between 70 and 90 per cent of stock market funds underperform their benchmarks over 15 years. Real skill in stock-picking is exceedingly rare.

    Of course, it’s no wonder that many ordinary investors look at past performance and choose to buy funds that have done well. That’s how the financial services industry sells itself: just buy the top-performing funds. Yet time and again it has been proven that past performance is no guide to future performance. Just because a fund has done well one year is no guarantee, or even indication, that it will do well next year. Again, according to Vanguard data, almost 70 per cent of the top-performing funds in any given year fail to repeat that top performance in the following 12 months.

    So don’t buy the top-performing funds thinking they will continue to do well. And don’t sell the bottom-performing funds thinking they will continue their losing streak. If you do so you are simply running up and down a normal distribution curve.

    So how do I look after my own money? I don’t bother chasing the illusion of outperformance from supposed stock-picking skill, that’s for sure. I buy passive or tracker funds that offer cheap exposure to general stock market performance. Or, if you like technical jargon, I buy Beta and don’t bother chasing Alpha.

    The Nobel prize-winning behavioural financial expert Daniel Kahneman wrote in Thinking Fast and Slow: ‘The illusion is that people who pick stocks are exercising high-level skill.’ Note the term ‘illusion’. Fund managers want to attribute outperformance to their skill and not to being lucky enough to find themselves on the right-hand side of a normal distribution.

    Kahneman continues: ‘The illusion of skill is deeply ingrained in the culture of the financial services industry. Facts that challenge basic assumptions — and thereby threaten people’s livelihoods and self-esteem — are simply not absorbed. We know that people can maintain an unshakable faith in any proposition, however absurd, when they are sustained by a community of like-minded believers. Given the professional culture of the financial community, it is not surprising that large numbers of individuals in that world believe themselves to be among the chosen few who can do what they believe others cannot.’

    Don’t buy into this illusion. Statistics and skill are very different things.