Fooled By Manager ReturnsAdvisor Perspectives
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In nearly every profession, past performance is indicative of future results. When picking a doctor, contractor, professor, attorney or professional athlete, naturally the key criterion to consider is their historical track record. The expertise of skilled professionals should be evidenced with consistent outperformance versus peers. Furthermore, the logic follows that anyone can suffer through a short-term setback for a variety of reasons, but the elite performers should not be expected to struggle for an extended period.
The same reasoning unfortunately does not apply to selecting investment managers. In fact, the counterintuitive nature of successful investing often requires acting against entrenched emotional biases that are shaped by the normal life experiences described above. We will describe why the conventional, instinctive approach to making investment manager choices generally leads to poor outcomes and how investors can be fooled by manager returns.
The traditional approach
If you were to ask a professional consultant or investor how they select investment managers, they would likely walk you through a well-rounded approach that combines “hard” data (strong historical performance) with “soft” analysis (qualitative evidence of superior skill). In practice, however, the manager’s returns tend to dominate the hire/fire decisions while less objective qualitative inputs often yield to the appeal of recent, precise data points. These are often reinforced by managers, most of whom are self-marketing experts, who ably weave compelling (and usually unprovable) stories to rationalize their recent success and why it should continue.
While all performance is usually considered, the convention is to focus on returns during the previous five years. Investors tend to assume that managers who have outperformed over a period as long as five years must be highly skilled and vice versa. It can be emotionally validating to hire a manager whose strategy “has been working” in the current environment. This further reinforces a short-term hard data approach to manager research. As just one example, Morningstar’s widely followed star rating also heavily weights historical five-year performance.1
The emphasis on short-term performance is heightened after the manager is hired and decisions are made about whether to retain or terminate the strategy. The return comparison to a relevant benchmark and peer group rankings typically dominate the evaluations of the manager’s success. This is in part due to a behavioral bias, to attach more value to information that is simple, immediate and precise. Whereas qualitative inputs can be ambiguous and more difficult to evaluate. When monitoring results this closely, five years may feel like an eternity. Very few investors exercise sufficient patience to hold on to an underperforming manager for several years, let alone five.
Consequently, the traditional approach typically results in hiring recent outperformers and firing underperformers. You may have personally experienced the frustrating phenomenon of adding a historically outperforming manager who suddenly underperforms just after being hired. By selling low, investors cement the poor returns into their portfolio and then risk hiring another potentially underperforming manager the next round. This buy-high, sell-low discipline clearly doesn’t work well over time.
Investing is different
Extrapolating the recent past in the hiring and firing of investment managers produces poor results because of a few unique characteristics that differentiate this industry from most others. First, consistent outperformance is extremely rare. We conducted a study2 of the returns of thousands of equity managers using Morningstar. We split the performance into four equal five-year segments over the past 20 years and ranked all the managers by quintile3 within their appropriate size and style category. Not a single equity fund in the universe ranked in the top quintile over all four five-year periods, demonstrating the rarity of consistent outperformance!
Remarkably, even the top long-term performers can underperform for long stretches. Warren Buffett is widely considered to be one of the greatest investors of all time. Most investors would be surprised to learn that Berkshire Hathaway has underperformed the Russell 1000 Index over the past 15 years! His 20-year track record outpaces the index, but all of the outperformance came in the first five years. Likewise, the single best performing equity funds within each of the nine Morningstar size and style boxes (large-, mid-, small-cap and growth, value and blend) all underperformed their relevant indices for periods greater than five years (and on average about 10 years). Table 1 summarizes the longest stretch of years the single best performer trailed the appropriate benchmark.4
The second aspect of investment management that is different from other professions is that performance over five years is an unreliable indicator of future returns. Since most investors are highly influenced by trailing five-year returns in their hire and fire decisions, we examined whether the data supported such a strategy. We reviewed how the top performers five years ago did in the subsequent five-year period. We compared those results to the managers who were the worst performers five years ago. In order to make relevant comparisons among managers, we separated the analysis into the nine Morningstar equity fund segments. Counterintuitively, in seven out of the nine categories the bottom quintile strategies outperformed the managers in the top quintile. In other words, in most cases you were more likely to find a future top performer if you were fishing from the bottom of the pool rather than the top.5
Read the full article here by Alex Shahidi, Damien Bisserier - Advisor Perspectives