By Michael Nairne, Tacita Capital
On January 1, 2000, Jim Smith invested with Manager X. Jim had done his homework: he had compared Manager X's performance over the prior decade against the relevant benchmark. Although Manager X stumbled in 1990, his returns had beaten the S&P 500 every year after that. This outperformance is illustrated in the following graph. $1.00 invested with Manager X on January 1, 1990 was worth $7.05 on December 31, 1999 (see green), far in excess of the $5.32 earned by the S&P 500 (see red).
Jim had dug even deeper and reviewed several years of analysts' reports. They were unanimous. Manager X's performance warranted a role as core equity holding. Jim also hired his own financial analyst to analyze Manager's X's performance from a risk–adjusted perspective. Again, Manager X came through with flying colours. Although his returns were more volatile than the S&P 500, his higher returns more than compensated for the bumpier ride. With his homework done, Jim confidently selected Manager X as his core U.S. equity manager and allocated him a sizeable portion of his portfolio.
Fast forward to December 31, 2009, and Jim is ruefully assessing the results of his selection decision. Although Manager X's performance had outstripped the S&P 500 through the first half of the decade, he suffered massive losses in the market meltdown. Every $1.00 Jim invested with Manager X in 2000 was worth 72 cents (see green) at the end of the decade, more than 20% less than the 91 cents yielded by the S&P 500 (see red).
Analysts' reports now say this manager is too volatile to be a core holding. Jim's own financial analyst ran the numbers and now concludes that Manager X's recent risk-adjusted performance is poor. Jim wonders where he went wrong.
Jim's experience highlights the critical question of persistence in manager performance – whether a manager's past performance is predictive of his or her future performance. Certainly, considering the avalanche of media articles on top winning funds and the endless sales pitches to investors trumpeting "best in class" managers, one would assume that there is some reasonable level of persistence in performance.
Fortunately, we can garner insights based on empirical evidence, not puffery. Over the past half a century, there have been over 100 academic studies on the question of persistence in managed money performance. In 2003, the Fund Management Research Centre undertook a sweeping review of 49 of the most recent or robust of these studies from the U.S., U.K. and Australia in a report
to the Australian Securities and Investment Commission.
The report's major conclusions provide serious investors with some clear answers:
-
Good past performance is, at best, an unreliable and weak predictor of future good performance over the medium to long-run. Approximately 50 percent of the studies found no correlation at all between good past performance and good future performance. Where persistence was found, it tended to be short–term, i.e. only one to two years.
-
In those studies that found some level of persistence in positive performance, the outperformance tended to be small and in many cases, would be swamped by the cost of swapping between funds.
The report's authors hypothesized some reasons for the lack of persistence in past performance – style cyclicality; the erosion of competitive advantage as managers battle it out for better staff and methods, and; the negative impact of large capital inflows on outperforming managers.
The implications for investors are clear. An analysis of past performance alone is not sufficient for the selection of an investment manager. The chance of a given outperforming manager repeating this performance is almost random. An investor might as well use a dartboard if he or she is selecting managers solely on past return numbers.
If active managers are to be used in a portfolio, extensive investigation far beyond a simple review of past performance is required. A recent study, for example, suggests that analysis of a manager's portfolio holdings and the extent of their deviation from the benchmark as well as historic returns might point the way to managers who are more likely to exhibit positive performance persistence. However, once adjusted for style, size and momentum factors, much of this positive performance disappears and hence, more research is needed to validate these findings.
Finally, since managers as a group underperform the market by their fees and costs, the absence of positive performance persistence by active managers in general suggests that low cost, tax efficient index funds should form the core of a portfolio and that active managers, if included, should be used in a satellite role. Jim Smith wishes he had taken this approach in 2000.
February 25, 2010
Tacita Capital Inc. ("Tacita") is a private, independent family office and investment counselling firm that specializes in providing integrated wealth advisory and portfolio management services to families of affluence. We understand the challenges of affluence and apply the leading research and best practices of top financial academics and industry practitioners in assisting our clients to reach their goals.
Tacita research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it and is not intended to replace individually tailored investment advice. The asset classes/securities/instruments/strategies discussed may not be suitable for all investors and certain investors may not be eligible to purchase or participate in some or all of them. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Tacita recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor.
Tacita research is prepared for informational purposes. Neither the information nor any opinion expressed constitutes a solicitation by Tacita for the purchase or sale of any securities or financial products. This research is not intended to provide tax, legal, or accounting advice and readers are advised to seek out qualified professionals that provide advice on these issues for their individual circumstances.
Tacita research is based on public information. Tacita makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to inform any parties when opinions, estimates or information in Tacita research changes.
All investments involve risk including loss of principal. The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in securities transactions. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. Management fees and expenses are associated with investing.
