Lies, damned lies and investment statistics

3rd January 2012

This warning – or a formula very like it – features in the small print of every fund sold to private investors in the UK. There is officially no correlation between past and future.

So why do investment advisers and fund firms like to stress past performance? Why are there so many sites providing this information – often at a high cost to IFAs and other subscribers?

The simple answer is that past performance is usually the only way to differentiate scores of different funds investing in a similar way – or to sort out sectors that have done well from the laggards. Without past performance, investors have no guide.

They can, of course, choose to ignore or pay attention to the figures.

There may be a more complex answer, which does not sit easily with the warning. It is also difficult to prove. This suggests that success begets success, while it is hard to break out of failure. 

Successful fund managers can be a beacon for rivals to follow. If the less well-starred pick up on themes or individual stocks, this pushes up prices of these assets which the trend leaders already hold. That way top managers can either take a profit by selling into strength or enjoy a further boost. 

A successful fund attracts more money leading to potential economies of scale. These can be shared with investors – as in some investment trusts – or used to boost profits or to fund further and better research.

By contrast, poor performers may have a flight of investor cash. This leads to instability, the potential need to sell stocks out of necessity rather than because that is the right thing to do, leading to portfolio rebalancing costs at best and being left with rubbish stocks at worst.

There may also be a greater turnover of managers in failing funds, so there will be disruption to methods and the portfolio every time a new broom is brought in. A fund in the fourth quartile – the bottom division – may also be there because the fund management company does not bother with it.

While the FSA warning is undoubtedly true and no one should bet on the past replicating itself in the future, it does not mean that links between past and future are totally random.

Here are some pointers to a better understanding of investment fund statistics:

Annual management charge (AMC) – This is the headline figure taken by the fund manager each year (often on a quarterly or monthly basis). The money is used to remunerate the management firm, the adviser and the platform which sells to the adviser or individual investor.

Total expenses ratio (TER) – This adds the AMC to other expenses such as fees for registrars, auditors, legal matters, and for trading costs such as stockbroker fees. The TER must always be higher than the AMC. Subtracting the TER from the underlying performance gives the return to investors.

Net income reinvested – Most unit trust figures roll up any dividends paid out to investors, assuming they are basic rate taxpayers.  This puts the figures for a sector that produces income on an equal footing with one that is wholly oriented towards capital growth.  That way, investors can more easily compare risk with reward. The actual return to an investor who spends the dividends rather than reinvesting them (this is generally automatic) will be different.  And investors who pay more than the basic income tax rate will get less.  Pension fund figures are "gross income reinvested".

Offer to bid……This has been (the past tense will be explained later on) the preferred way of showing performance. It takes the price that the investor actually pays (that offered by the fund manager) and compares it to the amount the fund manager would bid to buy the investment back. An investor who pays £1,000 for a stake and, assuming the underlying investments remain unchanged, wants to sell it back will get less. It might be £970.  So the investment is down 3% for its owner even though the portfolio remains unaltered.  But the clear gap that used to exist between offer and bid has been substantially eroded by the use of single pricing where both sides of the equation have the same price.

Sell to sell – This shows the underlying success or otherwise of a fund manager rather than reflecting the return to the investor.  With the greater variety of remuneration methods due over the next year in the run up to the Retail Distribution Review, this becomes more important as it assesses how well the manager has performed. It includes net income reinvested.  The growth of  Z or clean fees shares and other share classes plus the trend towards advisers charging set annual fees means there will be a variety of cost structures for each underlying fund. It could be easier for investors to isolate the expenses from the performance and consider them separately.

Mid to mid – Investment trusts, which are stock market quoted unlike unit trusts (or Open Ended Investment Companies – OEICs), have prices quoted which are midway between the offer price (which the investor pays) and the bid price (where the investor sells). Depending on the investment trust, this "spread" can be a penny or two or far wider if the trust is small and/or rarely traded.  Mid to mid measures underlying performance, excluding the spread, stamp duty and broker fees which will impact on investor returns.

Cumulative performance – The most commonly used statistics show the growth or otherwise of a fund over a number of set periods – one year, three years, five years and ten years are the most usual. So the ABC fund has gained 23% over five years and so on.

Discrete performance – this breaks down the figures into consecutive periods such as years, allowing investors to compare shorter periods and to isolate periods of out-performance or under-performance.  So the above ABC fund might have achieved the 23% evenly across the five years, or it might have gained 40% five years ago and lost money ever since or it might have lost money for four years and then made a recov
ery recently (perhaps a change of manager or investment strategy).

Star ratings – A number of organisations apply stars or other devices, usually on a one to five basis.  This can be based on factors such as risk, turnover of stocks, variation against an index or sector, and consistency of returns vs the flash in the pan lucky bet. The ratings are often subjective and never forward looking.  They can also be controversial – funds may have to apply for a rating and pay for it; some agencies demand a higher fee if the rating is used in publicity. 

More from Mindful Money:

Are star fund managers out of fashion?

Is ‘disconnect’ set to become the new buzzword of 2012?

Say again? Mindful Money helps de-bunk investment jargon

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