Chasing performance

The most consistent pattern in retail fund flows is that money arrives after good performance and leaves after poor performance, which is the mechanism behind much of the behaviour gap.

The pattern

Documented across markets.

Fund flow data consistently shows money moving into funds, sectors and asset classes that have recently performed well.

Which means the average investor's money experiences a different set of returns from the fund's reported figures, since it arrives after the gains and frequently leaves before the recovery.

The effect is largest in the most volatile and most specialised products, where the recent performance that attracts money is also the most extreme.

Why it happens

The psychology.

Recency: recent outcomes dominate expectations about the future.

Salience: what has performed well receives coverage, which is how most people learn about it.

Regret: watching others make money produces discomfort, and participating relieves it.

Narrative: strong performance generates explanations for why it will continue, which are frequently persuasive and occasionally correct.

And social proof, particularly where a theme has become widely discussed.

The launch pattern

Which is instructive.

Fund providers launch products for themes and sectors that have performed well, because that is what sells.

Which means the availability of a fund for a particular theme is itself weak evidence that the theme has already performed well.

Studies of thematic fund launches have found that they tend to arrive after strong performance and to disappoint subsequently, with the funds themselves frequently closing after a few years.

Which is not a claim that themes never work — it is a claim about when they become widely available.

Mean reversion

Which complicates the picture.

Extended periods of outperformance by an asset class, sector or region have historically tended to be followed by weaker relative performance, and the reverse.

This is not reliable enough to time, and it is reliable enough to make chasing recent winners a poor default.

Valuation is part of the mechanism: strong performance raises prices, which reduces expected future returns for the same asset.

Which means the thing that has performed best has, other things equal, become more expensive and therefore has lower expected returns.

The selection problem

How most people choose funds.

Past performance is the most commonly used criterion in retail fund selection and is a weak predictor of future performance, which studies of persistence consistently find.

Star ratings based substantially on past performance have similar limitations.

Which means the standard selection process has limited basis, and the regulatory warning about past performance exists precisely for this reason.

Better criteria: cost, breadth of diversification, tracking quality for index funds, and whether the holding fits a stated plan.

What to do instead

Practically.

Decide the allocation first, then select low-cost broad funds to implement it.

Contribute on a schedule regardless of what has recently performed well.

Rebalance on a rule, which mechanically sells what has risen and buys what has not — the exact opposite of chasing.

Avoid adding holdings in response to performance.

Limit exposure to media covering recent winners.

And write down the reason for every holding, so that adding one requires articulating a reason other than recent returns.

The specific cases to watch

Where chasing is most costly.

Single-country funds after a strong run.

Sector and thematic funds generally.

Individual shares that have risen sharply and attracted attention.

Cryptocurrency and speculative assets during periods of enthusiasm.

Leveraged products, where volatility decay compounds the problem.

And active funds selected on a strong recent record, which frequently reflects a style that has been in favour and which will at some point not be.

The other direction

Which is equally costly.

Selling or avoiding what has performed poorly is the same error inverted.

An asset class that has underperformed for years is generally cheaper, which raises expected future returns.

Which is why abandoning a diversified allocation because part of it has lagged is a common and expensive decision.

The discipline of holding the unloved portion is what diversification requires, and it is precisely what most investors abandon.

The test

Before any change.

Would I be making this change if this holding had performed differently over the past three years?

If the honest answer is no, the change is being driven by performance rather than by reasoning, which is the definition of the problem.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.