Special Report on Peps and Tax Planning: Lies, damned lies and performance tables: Mike Truman explains how to dig out the consistent PEPs winners

A STANDARD warning on all advertisements for unit trust PEPs is that 'past performance is no guide to the future'. Is this true? And if it is, how is an investor supposed to decide which unit trust manager to bet on?

An investor looking to put some money into a UK income unit trust when PEPs started at the beginning of 1987 might well have looked at the performance tables issued by Planned Savings magazine. Since unit trusts are intended as a medium to long-term investment, the most appropriate period to consider would have been performance over the previous five years.

On that basis, the top five performing unit trusts were Equity & Law Higher Income, Gartmore Income, Key Income, James Capel Income and Target Income. The Planned Savings tables gave results before the initial charges on investment and after re-investment of net income. In a PEP the income would not suffer tax and would roll up gross, but initial charges would have knocked 5 or 6 per cent off the investment.

How would an investor in each of these unit trusts have fared over the next five years? None were in the top five for the following five years. Only one long-standing high performer, Key Income, was in the top 10, showing a 90 per cent increase over five years; and even it had dropped to the bottom quarter of the tables for three-year performance.

Of the others, Equity and Law was still in the top quarter of the tables, showing a 71 per cent increase, as was James Capel, with an 80 per cent increase. But Gartmore had slipped to below average, with a 56 per cent increase, and Target was in the bottom quarter of the table, with a 41 per cent return. The performance reversals over one year can be even more remarkable, especially when events like the stock market crash of 1987 intervene.

So why do performance tables sometimes mean so little? Where a unit trust has a highly erratic performance the most likely explanation is that it is following an aggressive investment policy. When this works it is spectacularly successful and lifts the trust to the top of the performance tables. But when the risks do not pay off the fund plunges down to the bottom of the list.

Another possibility is that the composition of the table itself is misleading. For example, a performance table for European unit trusts will include all trusts investing primarily in European stocks. Some will be general funds, others will be specialist funds, investing in one country only.

If this country's stock market out-performs the European average, specialist funds investing in it will automatically rise to the top of the charts. This can be exacerbated when the country in question has a small stock market with comparatively few shares to trade - the bull market attracts attention from overseas investors and the sudden influx of funds further fuels the market rise.

In early 1987 the UK stock market rocketed upwards. The performance in this period formed a disproportionate part of the growth shown over a three or five-year span, with the result that the same trusts tended to lead the tables over all time periods. This gave a misleading appearance of steady growth when in fact the bulk of the growth had been in the last six months.

More recently there is some evidence that small unit trusts which take their time investing funds have benefited from high interest rates. As money comes in it is held on deposit pending investment. Over recent years there have been many times when it was far better to be in cash than in the markets, so these funds have outperformed their competitors simply because of their interest income on funds awaiting investment.

So how should an investor use performance tables, if at all? They do contain useful information; there are unit and investment trust managers who produce consistently above average performance. But it is this consistent and above average performance which should be sought, not one-off superlative gains.

Rather than considering the 'top 10', look for funds that are in the top half of the table. See how the trust has performed in each of the past five years to judge whether the performance has been consistent.

Another way of getting the same information is to look at a graph plotting the performance of the trust against the average for the sector, which should be readily available. A consistently above-average performer will show the gap between the two steadily widening and climbing with a steeper slope.

Performance tables do not lie, but neither do they tell the whole truth. Use them sensibly and they should guide you to a consistent performer; use them blindly and you will be forever buying into markets when they are ripe for a fall.