Is follow the leader the best way to invest?

Past performance is a standard benchmark used by fund managers in discussions with financial planners, particularly when it comes to promoting an existing product line or the benefits of new products hitting the market.

However, over the past few years the whole idea of past

performance comparisons has come under increasing pressure from theAustralian Securities and Investments Commission(ASIC).

In late 2001, ASIC requested thatAXAchange a series of advertisements which used performance data after the regulator felt the numbers, which were hypothetical and not actual performance numbers, could mislead or confuse some investors.

That move capped off a gradual shift away from the use of performance data in advertisements towards a trend of outlining the competitive advantages of a fund manager and its products, often supported by research house ratings and industry awards. (An examination of ad vertisers in recent editions ofMoney Managementwill bear this point out.)

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But if this is truly the case then why is past performance still the only available measure of a fund manager?

The obvious answer is that it is the only universally available and agreed upon criteria available since issues such as strength of management, investment process, staff experience and types of investment will vary according to the biases of those considering those criteria.

For instance, an adviser who favours index style investments will look much differently on a small cap boutique manager than an adviser who may have wealth accumulator clients looking for outperformance in the short-term.

Yet any debate about past performance invariably touches upon the equally thorny issue of market timing and long-term investing.

So if advisers and investors are not to chase past performance but yet should not try to time the market, what are some strategies that can be applied to avoid having this year’s leader become next year’s follower?

Brace yourself, because it seems that past performance and timing can be used because it is the very thing that fund managers use themselves and research houses rate them on.

However, this point does have some caveats withMorningstarhead of consulting Anthony Serhan stating the two mantras on the folly of chasing past performance and market timing are generally true and especially so for inexperienced and unsophisticated retail investors.

Brillient!managing director and Portfolio Construction Forum publisher Graham Rich says as stand-alone statements, they are flawed if accepted as absolute truisms together, but he says the reason for this is the adoption of limited information.

“If you accept a single performance number by using a point-to-point timeframe, then it will be very difficult to trust the data. However, if you add more data points then it is easier to extrapolate potential outcomes better,” Rich says.

According to Rich, past performance needs to be considered as not just returns, which tend to be the focus, but also from a risk point of view. This means looking at multiple time points and rolling returns which will show the variation in the performance of a fund and make it easier to see negative or low return periods.

“If this information is blended correctly then there is actually increasing validity in performance information and so with a greater degree of argument you can look at past performance,” Rich says.

Select Asset Managementchief investment officer Dominic McCormick says every investment decision is a timing decision and the issue has become a contentious one due to some poor behaviour.

“The worst type of performance chasing is the one where investors look at the best sectors and make moves based on that. These are not making moves on predictions for the future but based on trends of the past and as an investment strategy, is next to useless,” McCormick says.

The problem, according to Rich, is that while we would all like to predict the future, we only have historical data to work from but if used correctly, it can provide a reasonable basis to go ahead.

Rich also says a low funds under management figure could also be used as a measure of a fund and that it could be poorly supported as a stand-alone vehicle, but may also be an indicator of a poorly managed fund.

Funds flow also acts as an indicator, with Rich stating there is good evidence suggesting outflows do cause problems with asset allocation which is why listed investment companies are gaining in popularity with managers who

can, in effect, lock in the investors’ dollars.

However, McCormick warns these figures suffer from a lag and while advisers may not see current performance and inflows, they will be able to see past performance with up-to-date inflows.

“There is a sizable lag and even when advisers hear, they don’t always act. So the challenge for them is to get pro-active research to provide insights and not reactive research based on past performance,” he says.

Both Rich and Serhan still warn against playing the odds when it comes to past performance and market timing.

“There has been a lack

of focus in portfolio construction which shows a lack of time and effort on the part of some financial planners. Most of the effort in the past has been in

tax arbitrage and technical issues, with the assumption this is portfolio construction,” Rich says.

“Poor markets have focused this issue more towards understanding the place and relevance of market movements and asset allocation, and in some cases it is not the role of the financial planner to take part in but they should at least understand the alternatives available to clients.”