On every mutual fund advertisement touting its track record is language mandated by the SEC to the effect that past performance does not guarantee future results. And the SEC is right; indeed there is little evidence in mutual fund performance statistics that past results have any predictive value at all.
But why is this the case? In almost every other field of human activity past performance does predict the future. A great violinist today is likely to be great tomorrow; similarly a heart surgeon, or a basketball player. Why is investment management one of the few spheres where yesterday doesn’t predict tomorrow? Answering this question is central to picking investment managers and strategies, so let me share some ideas.
If 1000 monkeys pick stocks by throwing darts at a stock table, 500 of them will do better than average in a year. 250 will outperform 2 years in a row; 125 will outperform 3 years….and so on until you have 30 monkeys with great 5 year track records. Quite a few of those lucky monkeys will be showing up in your office, running billion dollar hedge funds and encouraging you to invest. So the problem becomes: how to do you distinguish luck from skill in an investment track record?
The first thing we would do is determine if the track record could have been created with one or two simple ideas: e.g. buy value stocks, or growth stocks, or small cap stocks, or financials, or technology. This is easier said than done, and requires access to the return patterns of numerous indices and some familiarity with statistical techniques. At one time or another, any one of those ideas might have had a big payoff over a multi-year period. Most of the equity hedge funds that we have looked at have track records that can be replicated with some simple combination of long value, short growth or long small cap, short large cap. Getting a big idea right can reflect skill, but it could also be the music world equivalent of the one hit wonder—a matter of pure luck. The same could be said about getting two or three big things right in succession.
Suppose, for example, a manager had a great year 5 years ago, when he was running one tenth as much money he does today. If most of his or her winning positions could have been 10 times larger, that is a green light. But if positions that large would have represented a big percentage of the issuers shares outstanding, or many days of trading volume, that spells caution.
If the track record involves very active trading, one needs to analyze if, at his current size, his own purchases and sales would have moved the market significantly, or if his positions would have been virtually illiquid in stressful times. If that’s what the analysis shows, the yellow light is flashing caution.
All in the timing.
Some investment strategies amount to selling insurance against unlikely events. As an example, just has houses don’t often burn down, corporations don’t often default on their bonds. Investments in “junk bonds,” however they are leveraged or hedged, have that trait. Most of the time they will offer better returns; and at certain times in a credit cycle very impressive returns as the market psychology moves from fear to greed. And, of course, there will be the occasional default—simply a part of the game which will be offset by the results of the rest of the portfolio.
But the house analogy is a good one: most of the time when my house burns down it is an independent event, and doesn’t affect the chance of yours’ catching fire. But sometimes, my house burns down in a forest fire that engulfs yours and dozens of others at the same time.
Similarly, when a corporation defaults on its bond, it might not reflect just circumstances specific to that company. The default might be driven by a credit collapse where few borrowers are able to refinance in the ordinary course or an economic collapse where few are able to maintain profitability sufficient to service their debts. This is a classic field in which looking backwards will get you in trouble: long periods of good performance leave bond prices high, spreads to better investments squeezed tight, and create an environment where bonds can come to market with a diminished margin of safety and weak legal protections.
But when recent performance looks terrible, that is often a time of golden opportunity, where bonds can be purchased with very rich yields and at prices that offer plenty of upside. When investing in this kind of strategy, looking at an impressive track record is like driving a Ferrari with your eyes glued to the rear view mirror: you are apt to have a lot of accidents.
This is not meant to suggest that investment track records should be ignored: indeed it’s the very first thing you might consider in a quest for skilled managers. It just shouldn’t be the only thing.