FOOL'S EYE VIEW
Past Performance is a Guide to the Future

By James Carlisle
May 30, 2001

You'll have seen the words at the bottom of investment adverts "past performance is no guide to the future". The regulator makes them do it because the way that a unit trust has performed over the last few years has little to do with how it will perform in the future. The trouble is that the words are often taken out of context and their meaning gets confused. The truth is that past performance is quite definitely a guide to the future, but you need to be very careful about how you look at it.

Persistency in tennis

On Monday, Venus Williams suffered a shock defeat in the first round of the French Open at the hands of Barbara Schett. Are we to deduce from this that Schett is the likely winner when the two meet again? Of course not, but that does not mean that past performance is no guide to future performance. If we look at the results of the two players and their respective opposition over the last few years, we'll rightly conclude that Williams is very likely, though far from certain, to make her superior world ranking count (2nd against 25th). Pete Sampras makes an even better case for this. He's won 7 out of the last 8 Wimbledon men's titles. Who's going to win it this year? Who knows, but few would argue with the bookies who are making him 7-4 favourite to make it 8 out of 9.

The fact is that with tennis, there is a persistency in performance. The more a player wins, the more you can reasonably conclude that they're likely to keep doing so (all other things, like injuries, age and opposition, being equal). A player's ability and form persists from the last match into the next. In that way, it is a clear indicator of what might happen in the future.

No persistency in the National Lottery

The National Lottery is an example of a game in which there is no persistency. The prize draw last Saturday came up with numbers 3,15, 22, 29, 35, 49, but any Fool will tell you that this has no bearing whatsoever on the numbers that might be drawn next time. The Motley Fool UK Investment Guide, 2nd Edition, goes into this on page 259. In its first year of operation, a total of 312 (52 times 6) balls were drawn, meaning that we'd expect to have seen each ball, on average, 6.37 times (312 divided by the 49 balls).

Around this average, though, we'd expect to see a wide variation. Sure enough, the 5 was drawn an impressive ten times while the 39 made just one appearance. But it would be very wrong indeed to think that this meant that the 5 was any more likely to appear in the next draw, because there is no persistence. You wouldn't expect there to be any persistence (there is no link between one draw and the next) and, sure enough, that's just what the numbers would suggest to a mathematician if you let one loose on the data.

What about Unit Trusts?

So, are unit trusts like tennis players or are they like the National Lottery? The answer is that there are bits of both.

There is persistence in that, over the long term, a unit trust that invests in shares tends to beat a unit trust that invests in cash (since shares themselves tend to do better). There is also persistence in the effect of charges. These are like a leak in a portfolio, and index trackers, which tend to have lower charges, tend to beat the more expensive actively-managed funds. There's little or no evidence, however, to suggest that there is any persistence in the performance of the actively-managed funds. At any rate, if there is any persistence, then it is hidden by the greater effect of charges.

So, Fools, you shouldn't ignore past performance, but you should be very careful what you read into it. With unit trusts, the past performance data is giving a strong message to you that an index tracker will very likely beat the average unit trust in the future. According to research by the WM Company (commissioned by Virgin), over the 12 years to the end of 2000 the average index tracker return was greater than that of 70% of actively-managed unit trusts. This past performance is likely to persist into the future.

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