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The three signs of future underperforming funds

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Asset managers with a low information ratio are likely to be among the worst benchmark-adjusted performers over subsequent years, according to research.

The study, conducted by Andrew Clare, professor of asset management at Cass Business School, identified quantitative indicators that could help investors determine the likely future performance of their fund managers.

It also found that managers likely to underperform their benchmarks in subsequent years were those with a high fund turnover or that experienced high net fund inflows.

The research used a comprehensive data set comparing the performance of over 2,100 US mutual funds from 2000 to 2017.

Overall, the study found the size of a portfolio did not prove to be a consistent way of identifying outperformers.

However, it found some – albeit weak – evidence that both large and small funds subsequently produced poor benchmark-adjusted returns.

This, it suggested, was because at both extremes the funds suffered from a lack of fund manager attention.

The study said: “For the small funds, [could this be] because they are just not significant from a fee generation perspective, and the larger funds, perhaps because the manager does not want to rock the fee-generating boat?”

However, both net flows and fund turnover did produce fairly consistent subsequent returns, according to the research. Funds that received high net inflows in one year tended to produce poor benchmark-adjusted returns in the next year.

The authors remarked: “It seems plausible that in- and outflows distract managers from their investment strategies, making it difficult for them to implement those strategies.”

And they said there was similar evidence when using fund turnover as a criteria: “Funds that experience high levels of turnover in year t, tend to produce poor benchmark-adjusted returns in year t+1. High turnover has been linked to wealth-damaging behavioural biases, and it appears that there may be some evidence for this phenomenon in our results.”

Clare said: “Choosing the right active fund manager is clearly a challenge for all investors, given the wide range of choices out there. It is equally important to know when the time is right to switch investment funds from an existing manager to a new manager. Our research suggests avoiding investing with managers that produce a low information ratio, have high turnover or where the fund experiences high net inflows.”

The study was co-authored by Mariana Clare of Imperial College and supported by Inversis, the Spanish investment technology consultancy.

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