Seen a fund with eye-popping recent returns? Don't assume its outperformance will continue. The manager may just have got lucky.
Most people are familiar with a phrase like "past performance is not a reliable indicator of future results”. It’s a standard disclaimer which the Financial Conduct Authority requires all regulated financial businesses to include in their marketing materials, client communications and advertisements when discussing past performance.
The FCA insists on it for a very good reason — to safeguard consumers. Regulators know how tempting it is for investors to ignore the advice altogether, and for unscrupulous businesses to exploit our tendency to "chase performance" by investing in funds with eye-catching returns.
Financial history is littered with examples of “star” fund managers who spectacularly crashed to earth. The most commonly cited example in recent years is Neil Woodford, whose stockpicking expertise turned Oxfordshire-based Invesco Perpetual into one of the highest-profile fund houses in Europe. Alas, Woodford’s returns nose-dived when he set up his own asset management firm, and around 300,000 investors lost money.
Britain’s worst fund manager
A lesser-known case study than Woodford is that of Jayesh Manek. Born in Uganda, Manek moved to the UK and built a chain of pharmacies. But his real passion was picking stocks, and, in 1994, he won a “fantasy fund manager” competition run by The Sunday Times, turning a paper £10m into a staggering £502m.
News spread of this unlikely stock market guru from Ruislip, especially when, the following year, he produced returns of 580%. Eventually Manek launched his own fund, and even the revered investor Sir John Templeton entrusted him with £10m of his own money. Continued strong performance in the early years helped the fund to grow to more than £300m.
But suddenly the wheels came off. In the three years from its peak at the end of March 2000, the fund fell in value by 75%. Performance went from bad to worse in the years that followed, until it finally closed in 2017. Over the fund’s 20-year history, the broad UK stock market delivered a positive return of 263 percent, while Manek’s fund fell in value by 56 percent, earning him the title Britain’s worst fund manager.
The role of random chance
So how can Jayesh Manek’s meteoric rise and fall be explained? How can the same person, and the same strategy, deliver performance that was so extraordinarily good and then equally bad? The simple answer is that active fund returns owe less to skill than to random chance.
Markets are, broadly speaking, very efficient. At any one time, stock prices incorporate all available information, thanks to the constant and cumulative efforts of millions of investors trying to outperform the market. In practice, this never-ending competition makes the market almost impossible to beat.
Another important concept for investors to understand is what we call the paradox of skill. This refers to the idea that, as the overall skill level of fund managers increases, it becomes harder for any individual manager to outperform consistently. What’s more, when they do so, it’s more likely to be down to luck than skill.
Several academics over the years have tried to evaluate the relative roles of luck and skill in active management. In 1968, an empirical study by Harvard professor Michael Jensen found that the average actively managed fund was unable to outperform a benchmark portfolio that was adjusted for risk, even before taking fees and charges into account. In 2010, Eugene Fama and Kenneth French showed that the number of fund managers who outperform is even smaller than what we would expect by random chance alone.
Likely explanations
Distinguishing luck from skill in individual fund managers is very challenging. We don’t know for certain, but the overwhelming likelihood is that Jayesh Manek simply got lucky in those early years. Sadly, unlike skill, luck is not repeatable, and, almost inevitably, his luck ran out.
Interestingly, it came to light when Manek’s performance began to deteriorate that he may have submitted multiple entries to that Sunday Times contest, which would have greatly increased his chances of success.
This phenomenon of starting with a number of strategies, then disregarding those that fail and pointing to the winners as evidence of skill is known as backfill bias. It’s a form of selection bias, or survivorship bias, and it’s remarkably common in the fund management industry. Several fund houses have been known to engage in it.
You could even argue, in fact, that the fund industry itself is largely built on backfill bias. Why? Because there’s always a vast array of funds for investors to choose from. Simply by the law of averages, there are bound to be funds with impressive recent returns. By closing funds which have underperformed, or by merging them with more successful funds, fund management companies are able to give the impression that their stockpickers are genuinely skilful.
Fund survivorship rates are generally very low and have declined still further in recent years. According to the Global Asset Management Report 2024 from Boston Consulting Group, only 37% of all funds launched in 2013 still existed by 2023. This is a significant decrease compared with 2010 when 60% of funds that had been launched a decade earlier were still in operation.
Lessons for investors
So what are the key takeaways for investors?
First, never ignore the warning about past performance and future results. It’s there for you protection.
Secondly, when you see a “star” manager attracting attention after strong recent returns, remember that it certainly doesn’t mean they’re skilful. There will always be funds that have smashed the competition in the recent past. But, as we saw with Jayesh Manek, Neil Woodford and many others, today’s hero can easily become tomorrow’s zero.
Thirdly, don’t pay attention to so-called “best-buy” fund lists or articles in the weekend money pages that appear to recommend a particular fund or strategy. Anyone can see who the recent winners are, but predicting, in advance, which funds will outperform in future is exceedingly difficult.
Finally, stop trying to beat the market anyway. It simply isn’t necessary. By investing in a simple portfolio of passive, or at least broadly passive, funds — and simply staying invested — you can outperform the vast majority of active investors in the long run.
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