How do you use fund performance data? Every investor has his own opinion on the topic, from those who obsess about every basis point when poring over return statistics to those who ignore past performance entirely.
Of course, there's no right or wrong answer. How one uses performance data is a matter of personal preference. But some investors make the mistake of looking at past performance alone when making investing decisions, and it's easy to understand why. Trailing-return data, for example, is easier to understand and takes a lot less time to research than a fund manager's strategy and process. Furthermore, performance data speak directly to what many investors care about most: how investing in a fund might be able to help their money grow. And despite all the disclaimers about past performance not necessarily representing future results, some investors have a hard time resisting the data.
To help put performance data into context, we asked some of Morningstar's in-house experts how they use it to evaluate funds. Here are their replies.
Jeff Ptak, president and chief investment officer of Morningstar Investment Services
Performance should be a single input into a process, not a divining rod. It really should play a small, confirmatory role. For instance, what does the fund's track record tell you about its investment style? What does it reveal about how the manager has executed his approach? Can you reconcile the way the fund has performed to the manager's stated investing discipline? How has it done during certain, more-telling time periods (such as market downdrafts or sharp rallies)?
Ideally, one would consider performance at the very end of the diligence process, with other factors (such as, prudence and repeatability of strategy; manager's depth, breadth and continuity; investor-centricity of manager and parent firm; competitiveness of expenses) taking precedence. In that way, past performance doesn't come to tinge the way we look at other factors that are arguably more predictive. The performance assessment itself should not be too pastry-cutter--one size doesn't fit all, it really depends on the makeup of the fund concerned--and tempered by the reality that returns tend to be mean-reverting, with stylistic biases and luck playing a big role in explaining out- and underperformance.
(Morningstar Investment Services, Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc.)
Russ Kinnel, director of mutual fund research
Performance data are remarkably informative. Their predictive power is limited, but you can still learn quite a lot about performance. For the big picture, look at how the fund has done during the manager's tenure versus its benchmark and peer group. Too often investors look at short time periods. If a manager has been at the fund for 12 years, you should look at the whole 12 years. On the flip side, if the manager has been there for one year, you can throw out the history beyond that.
Just as useful, however, is the annual-return data. Even if a fund has a great 10-year return, it might have had two awful years along the way. I want to see how it did in absolute terms and compared with its category and benchmark. For starters, you should be prepared for losses in a single year that are even a little greater than any past loss. Check out an equity fund's performance in 2000, 2001, 2002 and 2008 and you'll know how it's done in bear markets. Check out its returns in years like 2003 and 2009 to see how it did in rallies. In addition, you want to know how much it diverges from peers and the benchmark so you can use it properly in a portfolio and have realistic expectations.
Christine Benz, director of personal finance
For me, performance data are only helpful when used in conjunction with my understanding of a fund's strategy. If it's a fund I don't know well, I use past performance to help me understand what kind of style the manager has. If it's a fund whose strategy I think I understand, I use performance as an assurance that the fund is still filling the role I thought it would.
For example, has the fund tended to hold up well on the downside, indicating a bias toward conservatism? Does it exhibit the opposite pattern, falling further than its peers in down markets but screaming ahead during rallies? Or is there no rhyme nor reason behind when the fund does well and when it does not? That's often an indication of an idiosyncratic strategy that's changeable or highly dependent on the fortunes of its top holdings.
I conduct that kind of analysis initially when I'm getting to know a fund, and on an ongoing basis to make sure a fund is performing in line with my expectations. When I was a fund analyst, I used to pride myself on knowing which of my funds would be doing poorly in a given market environment and which weren't--even before I saw their returns or rankings. That told me I understood the strategy and the role that fund should play in an investor's portfolio. If I knew a large-cap fund usually bought smaller large-cap firms than its peers, I'd expect it to do well in a smaller-cap-led rally, or I'd know that a given manager would probably be benefiting from strength in biotech stocks because he always had a bias towards that industry.
Sam Lee, ETF strategist and editor of Morningstar ETFInvestor
Past performance is by itself a mostly useless and potentially harmful measure by which to judge a strategy. First, it's sensitive to the start and end dates at which you look. Second, the periods during which performance data are available are often too small to be meaningful. A strategy with a great three- or five- or even 10-year record is likely not going to continue to outperform in a meaningful way (otherwise picking a winning strategy and making lots of money would be easy). If you're going by performance alone, you often need decades of performance data to come to a statistically meaningful conclusion, and that's assuming the process generating those returns doesn't fundamentally change. Finally, strong historical performance in an asset class or strategy often suggests the asset is expensive or the strategy is crowded and should therefore be avoided.
The real value in using past returns is to supplement, not dominate, a holistic assessment of a strategy or asset because a good strategy or asset can experience years of bad returns, and a bad one can experience years of good returns. Past performance rarely provides enough information to strongly affirm or disconfirm a strategy's merits. When it does, it's usually to disconfirm. (Poorly performing active managers tend to experience persistent underperformance.)
For these reasons, I tend to focus my energy on identifying strategies with strong economic intuition behind them, confirmed by multiple independent researchers as having worked during many decades and in many different countries.
Eric Jacobson, senior fund analyst
On the bond side, we tend to look a lot at specific time periods that characterise particular market events. For example, the third quarter of 2011 was especially bad for riskier assets and an excellent time to hold Treasuries. (2008 looked a lot like 2011's third quarter, only much worse.) How well or poorly a fund performed in a specific period often says something about how much risk it was taking at that time, whether its duration [a measure of interest-rate sensitivity] was particularly long or short, and so on. More recently we've been looking at the May/June 2013 period. Interest-rate sensitivity, Treasury Inflation-Protected Securities and emerging-markets bonds were all negatives during that stretch. Calendar-year returns can be useful in this context also.
Other than that, we often try to look at a fund's record during the time its manager has been in charge. The virtue of that number is simply that it doesn't introduce overlapping time periods. I look at trailing returns a bit more carefully and in a more nuanced way because of the fact that they overlap so much (that is, the three-year return is also represented in the five-year number, and each can change quickly if a particularly strong or weak period rolls off, for example).
Michael Herbst, director of active funds research
As an analyst, I look at performance from a number of angles. For instance, I’ll look at absolute, relative and risk-adjusted performance during a fund manager's tenure to see how the fund has fared versus its benchmark, investable passive offerings and actively managed rivals. I'll also look at those measures during trailing periods, typically emphasising the five- and 10-year periods; one thing to remember there is a fund's historical performance can look much different once key events, such as 2008's crisis, roll off the record. Across those time periods I'll look at downside capture to get a better sense of how defensively a manager has run the fund because it can be painful to recover from losses. I look at those other metrics to determine how successful a manager or fund has been at executing its strategy, and to get a better sense of what investors can reasonably expect going forward. That's because a big risk of any fund is the one staring back at you in the mirror--if I know when a fund should shine or when it might crater, I'm less apt to buy or sell it at the wrong times.
In my own investing, before I even get to performance I assess the stability of a fund's management, the stewardship of the firm backing the fund, and expenses. Ultimately I can't control performance; what I can control is limiting the risks related to manager turnover, poor stewardship and high expenses. If I can get comfortable in those areas, then I'll look at performance from the angles described above to decide for myself where a fund will fit in my portfolio, when it would make sense to take gains, and when I should plan to have money available to buy additional shares after a fund takes a big hit.
Dan Culloton, associate director of fund analysis
I look at performance last, or at least try to, because as we all know, it's no guarantee of future results. I usually default to the longest possible period, whether that be the start of the tenure of the lead or longest-serving manager or the inception of the fund. Within that time frame I'll look at cumulative, annualised, calendar, quarterly, rolling and specific time periods to see how a fund has behaved during various time spans. Within those time frameworks I'll often look at absolute returns and the fund's returns versus its prospectus benchmark, category peers and other peer groups, indices, and rivals that I think might be relevant. Risk-adjusted returns—Morningstar’s measures and Sharpe, Sortino and other information ratios--are helpful, as are simple measures such as standard deviation and upside/downside capture ratios.
All this is just noise, though, if you don't connect it to what you know about the process and portfolio. Is the performance consistent with what you would expect from this approach and these holdings? What do the holdings and the historical track record say about future risks or prospects? What should investors expect?
