By: Frank Armstrong
By: Frank Armstrong, CFP, AIF
I often encounter investors that still believe that the most important criteria for selecting an investment manager is past performance. This can lead to some mighty strange encounters. They look at me as if I were just a few bricks short of a full load when I tell them that past performance is useless information. “Performance is all there is!” they say, with more than just a little irritation, impatience and condescension.
I hear myself in those words. That was me just a few years ago. I assumed that investment management skill was like landing an airplane or hitting a tennis ball. Selecting individual stocks with greater than average potential, and avoiding market turndowns could be learned. Some folks could master these skills, and the few masters would be evident to all. Of course, the primary indication of investment management genius should be past performance. Finally, superior past performance should be a reliable predictor of above average future performance. Any fool can see that. Right?
It turns out there is a simple test for this hypothesis. Let’s journey back five years to January 1993. We fire up our Morningstar database, select all growth funds (for example) that then had five year track records, then sort for highest past five year performance. (Morningstar hadn’t yet developed their style boxes, so these groupings were state-of-the-art then.) Finally, we select the top 20 funds in each group.
What a magnificent group of managers! No doubt about it, these guys have it together. In every category, with uncanny skill these Masters of the Universe have trounced the appropriate indexes. What a convincing demonstration of The Right Stuff! Here is how the average performance of our heroes stacks up against the indexes.
Our heroes collectively beat the index by 5.32% per year. And a $10,000 invested in the funds would have grown to $27,890 compared to a paltry $22,349 in the S&P 500 Index.
Fittingly, their achievements will be widely trumpeted, and the press will lionize them. Investors will shower them with new money with the certain expectations of future excess returns. Of course, with demonstrated genius producing performance like this, only naive investors would opt for “mediocre” index like returns.
We will divide our investments equally between the top performers, and follow our heroes for a further five years to prove once and for all that past performance is a reliable predictor of future performance. A few funds (Idex) disappear through mergers and change objectives, so we throw them out.
Whoops! The results are not at all what we expected! Our heroes and idols have cracked and tarnished. Their Right Stuff has all oozed out right before our eyes.
Here is how our heroes did during the second period.
(Yellow indicates second quartile performance, red is bottom half of all growth funds for the five year period.)
Choosing funds based on past performance turns out to be a losing strategy,and relative to the na”ve index approach a costly mistake. The heroes averaged a mere 16.33% while the S&P 500 Index turned in 20.25%. Our $10,000 invested during the second period with the heroes produced $3840 less than the Index.
You will get similar results no matter what time period and what domestic equity category you compare.
If past performance is not a reliable indicator of future performance, then the whole case for management skill collapses. Past performance may simply be a random result indicating luck, not skill and cunning.
The implications for active managers’ future employment are pretty grim. If investors ever catch on to the reality that management selection is an un-priced risk with high negative expectations, lots of fund managers will have to obtain honest employment.
Viewed from another perspective the investor must consider the proposition that markets bring returns, not the skill and cunning of active managers. It turns out that market or index returns are very fine indeed. And, the dumbest investor alive will attain those returns by simply buying an index fund.
If an investor can’t be highly confident that the decision to hire a manager will result in better net performance than his benchmark (the appropriate index) then s/he should certainly prefer the index approach. The index offers the lowest cost, lowest risk approach to obtaining market returns.
Where are they now?
Yesterday’s heroes are doing quite nicely, thank you. As a result of their past good fortune, investors threw money into their funds at record levels. With those giant cash inflows, fees for the lucky few managers grow exponentially. While the skill of a fund’s managers is questionable, a fund’s reputation, suitably enhanced by deft marketing, has great measurable persistence and value. Past performance is a remarkably reliable predictor of future cash flow into a fund. While the new investors suffered below average returns, the managers grew truly rich. It’s almost enough to challenge your faith in the efficient market theory.