When it comes time to choose a mix of funds, the investor or plan administrator is usually given only two pieces of information:

1. The disclaimer that “Past performance is no predictor of future results”

2. The past performance of each of the funds in question

A contradiction? Yes.

But more importantly, No.

A mutual fund of individual company stocks, for example, may have had a good year or two, or even a great decade of positive returns. But this fact says nothing about what it will do in the next decade.

The past performance of the mutual fund is no guarantor of its future performance. This makes the first proposition above a true one. We state this on all of our fund data because we are required to – and more importantly because it is true.

However, it’s important to talk about what we mean by performance for any given fund. If it means the likelihood that it will match the rate of return it achieved in the past decade, then there would be no predictive value from a fund’s past performance.

But, if by performance, we mean the fund’s likelihood of achieving a previously established market benchmark, then its past performance is very important to us. Did the fund meet its objective of matching market in the past? If no, then we have no reason to believe it will do so in the future.

This is a market-vs-manager issue. Do I put my faith for returns in the Market or in the Manager of my particular fund?

If a particular fund has as its policy to match, as closely as possible, the market components that it desires to own, and then does so with little variance over the preceding decade or two, and if these results are rated by GIPS (see last week’s post) so that it is clear that investors who own these funds are actually achieving, within variance, these market benchmarks, then the past performance is helpful information.

But those conditions are almost never present. What happens instead, particularly inside of 401k plans, is this buy-high-sell-low pattern:

Step 1 – Investor or plan administrator chooses a set of funds based on data that confirms these funds have done well in the past. What is “well”? Typically, that they achieved a return more favorable than the S&P 500 index. They may even have earned 4 or 5 stars from Morningstar, Inc.

Step 2 – Investments are made over time into this set or a subset of these funds. Uneducated investors armed with irrelevant data make choices to own funds for which they have no clear plan for holding accountable.

Step 3 – A few years pass.

Step 4 – The plan administrator, in the annual investment review with the investment firm, is shown a few new funds that recently achieved a five-star rating. These funds are recommended instead of a few funds that are currently owned which have recently underperformed the new ones. The trade is made to the new funds.

*** No one remembers that the funds being traded out were once five-star funds! ***

Step 5 – The investor/participant sees this new data and makes some changes in time to exit some of the funds they own that have done less well and to purchase a couple of these newer and better performing funds.

The result of this process? That the investor has bought high and sold low.

** Raise your hand if this has happened to you.***

Frustrated yet?