By: Frank Armstrong
*As seen on Forbes.
The only thing Wall Street tells you that you can take to the bank is: Past performance is no guarantee of future performance. They are required to tell you that, usually in little tiny print. Then as they shamelessly tout their top performers they go right on to imply that it’s not true.
In any game with about a thousand competitors, a few of them are most likely to have outstanding results. If those contestants consistently replicate their success we can surmise that they have skill. Baseball is a game of skill and we can expect the Yankees to rise to the top of the rankings and for the Marlins to sink.
If a contestant can’t consistently replicate their success, then they probably benefited from pure dumb luck. In fourth grade I once hit a home run even though my batting average was indistinguishable from zero. Pure dumb luck.
So, if success is reliably repeated, it’s probably skill. If not, it’s probably luck. What will this tell us about investment managers? Could a fund with an outstanding five year track record reliably repeat that performance?
Fortunately, Morningstar can provide us with just about anything you would want to know about past fund performance. So, let’s take a walk back in time to January 1, 2009 and look at everything it was possible to know about past fund returns. I searched for the top twenty domestic large company funds for the previous five years. To keep the comparison from being tainted by foreign exposure I screened out those that had more than 10% invested out of the country. After the adjustments 213 funds remained. You may recall that this five year period was particularly interesting, so we might assume that the top managers really had their stuff together.
Our top twenty funds turned in heroic returns compared to the appropriate benchmark S&P 500. They trounced it! With their top decile performance, these managers are certified Masters of the Universe! If past performance were any indication of future performance you surely would have wanted to buy into these funds. Then all we need to know about investing to obtain mind boggling results is to troll Morningstar’s data base for top performers.
The benchmark, S&P 500 lost 2.19% compounded annually for the period, so any manager with a positive return must be a genius, right? And the ever present Ken Heebner of CGM Focus beat it by 10.77% compounded annually. Heebner’s highly concentrated portfolio of his very best ideas was more than twice as volatile as the benchmark. But, hey, he’s a winner and unlike mere mortals, he fears not a little extra risk.
Now let’s fast forward to see how our heroes did in the next five year period. Not so great actually.
Heebner’s CGM Focus Fund continues to exhibit unusually high risk, but falls to 212 out of 213 in the group, also holding down last place for four of the five years. Has he lost his Mojo? Or, did he ever really have any?
We shouldn’t pile on Mr. Heebner, because during the second five year period not one of our top twenty performers in the first period beat a simple S&P 500 index, and all were in the bottom half against their peers.
So, is past performance indicative of future performance? Is performance chasing an appropriate investment strategy? Does the claim that superior active management adds value over time appear credible? Apparently not.
If past performance cannot predict future winners in the active management arena, what criteria can we use? We know in advance that some managers will beat the market. It always happens. And there are always winners in the lottery, but the expected return in the lottery as an investment is dismal. A good active manager is one that consistently adds value. If any actually exist, it’s highly unlikely that we can identify them in advance.
It’s fiendishly hard to beat an efficient market. No matter how bright your manager is or how good his past returns appear to be or how often you see him on TV, during any particular time period his chances of adding value above an index are dismal. The very highest probability is that he will lose value compared to market returns.
The sorry truth about active management is that it introduces another risk on top of market risk. And manager risk is not compensated by higher expected returns. It has a highly reliable negative expected return. Active management is a losing strategy that informed investors are abandoning in favor of lower cost, lower risk, lower tax cost and higher expected returns from passive strategies.
It’s important to understand that management risk cannot be diversified away. Since they were all losers, no possible combination of the twenty top performers in the first period would have beaten the dumb index during the second period.
Other credible studies show that it’s a virtual certainty that the more active managers you have in your portfolio, the more likely they are to lose value compared to the market. What you gain from the few winners in your holdings will be swamped by the underperformance from the remainder.
The heroes we identified in the first period were actually charlatans that could not and did not deliver. And where are these heroes now? On CNBC still selling their tired old snake oil story. Are you still buying?