Rob Gleeson (pictured) head of FE Research, says they must dig deeper, paying close attention to a number of other factors. He says the first thing to do is look at the consistency of a fund’s past returns.
"When considering a fund, investors need to look at its discrete performance as well as its long-term performance," he said.
"This means you can see if the fund's performance is repeatable, or down to the odd good year."
One of the places where the importance of consistency is most apparent is in the IMA UK All Companies sector.
According to FE Analytics, the three best-performing funds in the sector over five years are Liontrust Special Situations which has returned 113.9 per cent, Standard Life UK Equity Unconstrained with 110.63 per cent and CF Lindsell Train UK Equity, with returns of 110.14 per cent.
All three funds have massively outperformed the sector average over this time.
Performance of funds vs sector over 5yrs
Source: FE Analytics
Liontrust Special Situations and CF Lindsell Train UK Equity – both of which have a five crown-rating and are run by FE Alpha Managers – are the only two portfolios in the sector to have been top-quartile performers in each of the last five calendar years (2008 through to 2012).
Ed Legget’s Standard Life UK Equity Unconstrained fund invests in more cyclical and therefore more volatile companies, and as a result has had more of a bumpy ride over the last five years.
The fund has performed well in rising markets. When they rallied in 2009 following the crash, Standard Life UK Equity Unconstrained was the second-best performing fund in the sector; it also beat every other fund during the rally of 2012.
Despite this, its losses of 40.41 per cent in 2008 and 20.21 per cent in 2011 meant it was a bottom-quartile performer in each of those years.
Gleeson says investors must also look at the performance of the fund against the index it is trying to beat.
"This is especially the case in the IMA UK All Companies sector, as there are a number of mid cap funds in it," he continued.
"They might have outperformed against the rest of the sector because they invest in a different area of the market, but when you look at its benchmark or the index it may well have underperformed."
"You need to identify and compare the market the fund is in."
Gleeson says the next element to look at is the fund's ongoing charges figure (OCF) and whether or not it carries a performance fee.
"Investors should understand the impact charges have on the fund’s performance, as low charges don’t always mean good value."
"Then they must be aware of performance fees, because if a fund has underperformed then those performance fees will have had no impact."
JO Hambro Capital Management is an example of a fund house that uses performance fees in order to align the interests of both the investor and the fund’s management team.
It typically charges 15 per cent on any ouperformance of the fund's benchmark over one year. Performance fees are common with investment trusts and open-ended absolute return funds as well.
"For instance, you could think you are buying a fund when it is rock bottom and so you will be riding those returns as the fund’s performance improves, but performance fees will take away a lot of those returns," Gleeson added.
Another method investors can use to analyse a fund’s performance is looking at ratios, such as Sharpe.
The Sharpe ratio helps to measure whether a fund’s past outperformance is more to do with carefully planned investment decisions or because the manager took on excessive risk.
If the fund has a high Sharpe ratio this means the performance was a result of calculated judgments.
However, Gleeson says that using ratios is not for every investor.
"It is and it isn’t, ratio analysis is more of an art than a science," he said.
"A lot of IFAs don’t necessarily use them because they don’t understand them and also investors can get too hung up on things such as alpha."
"To be honest, it is like looking into one of those magic balls: if you stare long enough into them something could appear, but it is a difficult thing to do."
"With Sharpe ratios there are so many variables. People like rules of thumb and so they want to think a high ratio is good while a low one is bad – there is more to it than that and it can be deceiving."
Gleeson says that for investors who use passive funds, there is one performance figure that is vital.
"With passive funds, you can look at their tracking error as that shows you how differently the fund is behaving to its benchmark."
"The Holy Grail is a fund with zero tracking error and low costs, but those funds don’t exist."
"If a passive fund buys and sells every stock in the index, investors are getting the best access to that market, but they are normally paying for huge trading costs. There is usually a trade-off with passive funds between their tracking error and costs."
"Some will just hold 30 stocks in that index and will try to replicate the market by holding one or two stocks from each sector in order to keep costs down. However, Vanguard has come along and buys every stock on the index and has low costs."
One of the best examples of this is the Vanguard FTSE UK All Share Index fund. It was launched in December 2009 and, as the graph shows, it has closely replicated the returns of the FTSE All Share over three years.
Performance of fund vs index over 3yrs
Source: FE Analytics
The fund has an OCF of just 0.15 per cent and its tracking error over three years is just 0.33 per cent.
"Vanguard funds tend to have a high minimum investment though, so you should shop around the platforms to get the best deal," Gleeson added.