By Emily Doak, Managing Director of ETF Research for Charles Schwab Investment Advisory.

Charles Schwab: Why an ETF’s past performance can be misleading.

Almost everyone can name a sports team that always seems to be “in-the-hunt” for the playoffs or a superstar athlete that has dominated his or her field for decades.

Sometimes fund managers make similar claims about their ETFs’ performance by touting their star-ratings, analyst recommendations or sky-high since-inception returns.

Even though funds are required by the US Securities and Exchange Commission (SEC) to include warnings that past performance is not a guarantee of future success, it’s difficult to ignore the performance information displayed prominently in charts and graphs, and, like sports fans, investors sometimes get caught up in the excitement swirling around a “winning” fund.

Chasing performance

“Performance chasing” is when an investor chooses a particular fund based largely on the returns it generated in a prior period. In 2007, the SEC warned investors about performance chasing when selecting mutual funds, and we believe this warning is equally applicable to ETFs. Investors who choose funds primarily for their strong track records are often disappointed.

Case study #1: EMQQ

For example, the Emerging Markets Internet & Ecommerce ETF (EMQQ US) was launched in November 2014. During its first two years in existence, EMQQ’s performance was choppy, and the fund had only $40 million in assets as of the end of October 2016.

However, in 2017 and early 2018 the fund experienced a period of positive performance. Its strong returns during this period seem to be correlated with the substantial inflows that followed. Between January 2017 and March 2018, investors added nearly $430 million in net inflows. At its peak, in January 2018, EMQQ’s net assets were over $521 million.

While a hypothetical investor who bought $10,000 worth of EMQQ shares in January 2016 (well before the fund went viral) would have had an investment valued at nearly $16,000 at the end of Q1 2019, a performance chaser who invested $10,000 during the months with the biggest net inflows (July 2017 and January 2018) would have had an investment valued at only $9,456 or $7,813, respectively, as of 31 March 2019.

Performance and flows for Emerging Markets Internet and Ecommerce ETF (EMQQ US)

Source: Charles Schwab.

The table below shows the performance for EMQQ as of 31 March 2019.  While most of the returns below are positive, the dates over which they were calculated do not reflect the negative returns experienced by investors who bought shares during the months with the largest inflows.

Performance report for EMQQ as of March 31, 2019

Source: Charles Schwab.

Case study #2: SLVP

Another example of performance chasing can be seen in the iShares MSCI Global Silver Miners ETF (SLVP US) where strong performance in 2016 attracted outsized inflows. The fund drew in over $50 million between February and September 2016.

While a hypothetical investor who bought $10,000 of SLVP shares in January 2016 would have had an investment valued at over $15,500 at the end of March 2019, a performance chaser who invested $10,000 during either July or August 2016 (the months with the biggest net inflows) would have seen the value of their investment decline to $5,309 or $6,097, respectively, by 31 March 2019 (see chart below). Needless to say, investors looking for a triple-digit repeat of 2016 have probably been disappointed.

Performance and flows for iShares MSCI Global Silver Miners ETF (SLVP US)

Source: Charles Schwab.

As you can see in the table below, only SLVP’s average annualized performance for the three-year period is positive.

Performance report for SLVP as of March 31, 2019

Source: Charles Schwab.

Here are a few pointers to help you step up your game and avoid the performance pitfall:

1. Don’t discount diversification: It’s nearly impossible to predict which sector will perform well in a given year based solely on past performance, and even more difficult to say which industry (a sub-grouping within a sector) may outperform. ETFs tracking broader indexes may have a less exciting story behind them, but their greater diversification should reduce their volatility compared to niche funds.
2. Understand the metrics: If you choose to consider past performance when making an investment decision, take a careful look at how that past performance is reported. Annualized returns are the average, annual return an investor would have received in any year during the total time period with the effects of compounding included in the calculation. Funds are required to report one, five and 10-year returns (or since inception for those without sufficient history). However, other measures of performance are sometimes included alongside these figures and can be confusing. Here are a few performance metrics to watch out for:
   – Cumulative returns for periods longer than one year. These total, compounded returns for a longer time period may look impressive – and they should! The fund has had more time to perform in the market, and, mathematically, these numbers are similar to a sum rather than an average.
   – Alternatively, a fund may show annualized performance for a very short time period – this assumes that high performance during a very short time period (perhaps as little as a single month) continues at the same level for an entire year.
   – Finally, look for unusual dates, including returns shown “since inception”, which will vary between most funds (unless they were coincidentally launched on the same day), which can make comparisons between funds challenging.
3. Balance past performance with other investment considerations: Management fees, tracking error, bid-ask spread, risk (or volatility), and correlation with the other investments in your portfolio should also be considered when you select an ETF.

Finally, while no one can guarantee that your portfolio will end up in the “hall-of-fame”, knowing when to take past performance with a healthy dose of skepticism may help you avoid jumping on the bandwagon for today’s hot ETF only to be left with a fund that you’d rather cut from the team.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)