Jonathan Davis: Come on FSA, join the real world

Performance tables really do matter, says a report to watchdog from its own academics

No serious person I have met in the investment business thinks the Financial Services Authority (FSA) has covered itself in glory with its high-minded and frankly nonsensical opposition to the use of past-performance figures in the promotion and analysis of investment funds, a policy with which John Tiner, managing director of the FSA's consumer, investment and insurance directorate, has unavoidably been associated.

By refusing to include any past-performance figures in its own comparative tables on funds, the FSA has made itself look stupid, albeit (as so often with well-intentioned regulation) for the best of motives.

Two things that can be said with certainty about past-performance figures for unit trusts and other managed funds are (a) that there is precious little predictive value in them; and (b) that many investors buy funds on the assumption that past records are a sensible guide to how well they will do in the future.

In this latter behaviour, they are aided and abetted by the fund management industry, which has long used performance figures as a key part of its promotional and marketing material because, whatever academics may say, they do seem to work in influencing investors, and especially IFAs/advisers, on the funds they should be buying.

The trouble with the FSA's approach is that, in its manifest desire to protect consumers from themselves, it has boxed itself into the position of saying that because the information about past performance has no predictive value for future performance, it has no value when consumers come to buy a fund. Sadly, the second position does not follow logically. In pretending it does, the FSA looks grossly out of touch with the real world.

Now, after a painstakingly long time in which the industry and FSA have traded research papers criticising each other's position, the argument seems to be edging forward. The latest report by the FSA was published last week.

The authors, Professor David Blake, of University of London, and Prof essor Allan Timmermann, from the University of California, make useful and constructive points, despite having been hired, one suspects, to do a hatchet job on a consultants' report commissioned last year by the Investment Management Association.

To nobody's surprise, the academics do find the Charles River Associates report is full of logical and evidential holes, as you would expect given the evidence for persistence in fund performance is almost all against the idea that performance does persist in a consistent or predictable way. But the new report also concedes points to the industry's arguments.

For example, one of the authors confesses to having been won over by the evidence that, while better-performing funds tend not to remain superior performers over time, the same may not be true with poorly performing funds.

Funds that act like dogs have an above average chance of being dogs again, information which the academics concede may well be of genuine value to investors, if only so they can know what to avoid. Their says the comparative tables published by the FSA should contain data on performance figures.

But their argument is that the data which should be included is not "raw returns", but risk-adjusted performance figures, those that adjust the returns achieved for the level of risk the fund manager has adopted. There are well-established formulae for calculating this, and the information is widely available and widely used in the data services favoured by most professional advisers.

Professors Blake and Timmermann conclude, tellingly: "We are not persuaded that important information should not be published just because it might be misused. It is not clear that investors are protected from a failure to expose poorly performing managers." It will be interesting to see whether the FSA rises to the challenge of being told they have got it wrong.

What ordinary investors would make of risk-adjusted returns in another matter. Risk has always been the missing ingredient in most fund promotion.

Statistical analysis, the academics say, can be used to provide a range of possible outcomes a fund is likely to achieve, assuming it continues to be run in the same way. (On a somewhat similar basis, this is how the Bank of England presents its range of forecasts for future inflation in its regular inflation reports.)

The final point that the report makes is a more subtle argument for tracker funds. The authors say that, rather than putting, say, £1,000 into a high- risk and high-cost actively managed fund, investors can often achieve the same risk-return exposure more cheaply by borrowing a little money (say £150) and investing the original cash and the borrowed money (£1,150 in this case) in a tracker fund.

This is true, though one has to say it is a strategy that few financial advisers in my experience show any wish or capacity to understand, since it requires a knowledge of financial theory that few possess.

IT IS not clear whether the stock market is going to end this year higher or lower than last year, though my hunch is that it will be the former. Ken Fisher, the American money manager, told me that when the market does recover from a secular phase like the recent bear market, it tends to do so sharply. His figures show that markets often make what he calls big moves (up more than 20 per cent or down more than 20 per cent).

The dull, flat years are the exception, not the norm. Since 1926, the UK market has risen by more than 20 per cent in a year more than one year out of three. Only 40 per cent of the time does it produce a return of between zero and 20 per cent, and my guess is that this year is not going to be one of them, regardless of whether we are still in a secular bear market or not.

If the market does fall sharply from here once more, which is also possible, then the rebound when it comes will be bigger still.

davisbiz@aol.com