Past performance is no guarantee of future results.
We have all seen mutual fund ads stating this Securities and Exchange Commission (SEC) disclaimer while the remainder of the ad does nothing but display past performance, Morningstar stars (based on past performance), and how in the past the fund’s performance beat an index. Mutual funds want to make their returns looks as good as possible, and they argue that consumers want this data for comparison.
As we previously reported, a 2009 study found that the SEC-mandated disclaimer (“Past performance is no guarantee of future results.”) is completely ineffective at changing investors’ propensity to invest and their expectations regarding the fund’s future returns. The SEC-mandated disclaimer makes it sound like: “While past returns are no guarantee of future results, there exists some correlation which makes similar future results more likely, just not guaranteed.” This is not the case.
Selecting funds with lower expense ratios was better at predicting future success than using Morningstar stars partly because Morningstar stars use past performance as one of their indicators.
Although funds want to advertise their returns and investors want to see those returns, there is no simple way to make this data useful for consumers.
Past performance has little if anything to do with future returns.
We did a small study of 45 years of S&P 500 returns to prove the randomness and volatility of the market over one-month and twelve-month time periods in our article “Does Past Performance Have Anything To Do With Future Results?” The scatter plot graphs in that article should be fairly convincing: the market is inherently volatile.
That is why it is important to invest in securities which trend upward. Even though the returns of the past are the past and there are new unrelated returns coming in the future, it is still true that some investments trend upward while others do not.
In the thousands of publicly traded companies of stock investments, millions of people are working on your side. Your interest is congruent with theirs, and their very livelihood depends on your investment making a profit. Great well-financed companies that deliver products or services of real value create the upward trend of investment.
That being said, short term volatility can differ from the trend, and past performance reporting can be manipulated.
Past performance reporting can be manipulated.
There are many ways that managers can design their fund to appear to beat their supposed peers.
1. They compromise their index fund.
A fund which is categorized as a U.S. large cap stock fund can include a few mid-cap stocks or a foreign developed countries stock fund can include several emerging market stocks. This helps them beat their index by being slightly different than their index.
In each of these cases, you might be able to craft an asset allocation of lower cost funds which would perform better. For example, rather than one compromised fund, you’d have two on-target funds.
2. They select the type of performance and method of showing it.
Consider the different approaches taken in advertising. There are simple returns over different time periods, excess returns, risk-adjusted returns, and star rankings. None of these approaches help you craft an asset allocation, but they can manipulate the data to seem more appealing.
3. They pick the time period.
When you compare returns, most funds report the latest 1-year, 3-year, 5-year, and 10-year returns through the end of the last month. The major problem with this approach is that the past year (12 months) influences the return of each time frame. By rolling those time periods forward or backward one month, the figures can change significantly.
As an example, here are the 5-year rolling returns every year for the S&P 500 Total Return Index and Russell 2000 Small Cap Value Index:
|Time Period||S&P 500 Total Return Index||Russell 2000 Small Cap Value Index|
|6/30 2012 – 2017||+14.63%||+13.39%|
|6/30 2011 – 2016||+12.10%||+8.15%|
|6/30 2010 – 2015||+17.34%||+14.81%|
|6/30 2009 – 2014||+18.83%||+19.88%|
|6/30 2008 – 2013||+7.01%||+8.59%|
|6/30 2007 – 2012||+0.22%||-1.05%|
|6/30 2006 – 2011||+2.94%||+2.24%|
|6/30 2005 – 2010||-0.79%||-0.51%|
|6/30 2004 – 2009||-2.24%||-2.27%|
|6/30 2003 – 2008||+7.58%||+10.02%|
What good would it do you in 6/30/2008 to compare the 5-year annualized return of the S&P 500 Total Return (7.58%) to that of the Russell 2000 Small Cap Value (10.02%)? Or to know that after 6/30/2016 the comparison would be S&P 500 Total Return (12.10%) to the Russell 2000 Small Cap Value (8.15%)? How should you craft your asset allocation?
In investment management theory, five years is considered a fairly short time period for measuring performance. For our analysis of size and value premiums, we used 83 years of data. We consider anything under 7 years to be short term past performance.
Short term past performance is also no way to understand the risks associated with various investment choices. After 6/30/2016, were you to compare the 5-year annualized returns of the S&P 500 Total Return Index (0.22%) against the return of the Barclays 20-year Muni Bond Index for the same time period (6.45%), it is not clear what you would learn from that comparison. Nor do those two number suggest how to blend multiple indexes into a portfolio that you hope is on the efficient frontier.
The past performance of Chile is higher than that of the S&P 500 Total Return, but not for the most recent 5-years. Chile is extremely volatile, but adding a small allocation to Chile would have reduced the volatility of the overall portfolio.
The past performance of Real Estate Investment Trusts (REITs) is lower than that of the S&P 500 Total Return. Yet the REIT Index is beating the S&P 500 for the most recent 5-year period. Additionally a small allocation to REITs can boost the average return of a portfolio (despite the fact that REITs on average under perform), because of the rebalancing bonus and the fact that REITs have a relatively low correlation with the S&P 500.
None of this important information finds its way into the return of these indexes for the most recent 5-year period.
Past performance advertises nothing.
Using performance returns to advertise a comprehensive financial advisor’s approach is even more fraught with compliance concerns.
The total return of the composite investment mix under our management does not represent any individual client’s investment returns. If our composite mix tilts one way that doesn’t mean that you as an individual client will tilt that way. Each of our clients selects and approves of their own general asset allocation targets which will ultimately determine their future returns.
To further confuse matters, each month we produce the average return for a client (equal-weighted) and the average return for a client (dollar-weighted). We can also produce the average returns for each of our six asset classes separately.
The date you start tracking performance also influences the return computed. Should you use immediately after transferring the accounts under management, after the asset allocation has been set, or after trading has begun? We start returns from the moment we have data, which is as soon as even $1 is transferred.
Additionally, new clients bring all sorts of different highly appreciated investments to their portfolio. Selling everything and buying something else is rarely the best answer for the client. While the returns of those investments (good or bad) do influence our composite return, they don’t reflect our investment strategy.
Also, some clients stage large amounts of cash for upcoming withdrawals. This influences the composite portfolio returns but also doesn’t reflect our investment strategy.
For all of these reasons, using returns in advertising can easily be misleading.
Some advisors engage in even more misleading advertising of performance data. Consider these six assertions by RIA lawyer Brian Hamberger:
- Performance advertising need not include all of your accounts under management.
- Performance advertising does not need to be your actual performance.
- Performance advertising must be presented net of fees.
- Performance advertising does not require audited results.
- There is no minimum time period required for performance advertising.
- You can bring your performance with you.
Hamberger has no fear of showing off a registered investment advisor’s returns even when they did not actually achieve those returns, but I don’t agree with at least five our of those six assertions.
Accuracy and clarity are two of our firm’s primary values.
We do report time-weighted returns to our clients each quarter for their individual portfolios. In those quarterly reports, we currently report the time periods for 3-months, 1-year, 3-years, 5-years, and since inception. We also report individual calendar years, currently 5 individual years and then prior all together.
For each of these 11 different time periods, we report not only the time weighted return for the entire portfolio, but also six more returns for the assets which fall into each of our six different asset classes (Short Money, US Bonds, Foreign Bonds, US Stocks, Foreign Stocks, and Resource Stocks).
Although we report all of this to our clients, we have decided not to use composite returns in our marketing materials. We expect prospective clients to evaluate our services and investment philosophy without them.
After all, we certainly don’t keep anything a secret. We publish multiple articles every week!
I would suggest starting with our article “The Complete Guide to Creating an Investment Plan” which is a summary of these nine articles:
- Your Asset Allocation Should Be Priceless
- Does Every Client Get Put Into One Of A Few Investment Allocations?
- The Science of the Rebalancing Bonus
- Use Correlation to Define Asset Classes
- Defining Your Sectors
- The Asset Allocation Within Your Asset Allocation
- How to Select Securities
- The Art of the Rebalancing Bonus
- How Long Should I Give An Investment Plan?
After that, you could look at our Marotta Gone Fishing Portfolios, which is a simplified version of our investment strategy. We publish articles on the portfolio every year which discuss changes to the allocation as well as past performance.
Past performance has little if anything to do with future returns. We understand why prospective clients ask us to provide those numbers, but, for their own good, we politely decline.
Photo by Galina N on Unsplash