Republished courtesy of the National Post
by Tom Bradley
“Past performance is not indicative of future results.”
This warning label is required for investment products, but like the ones on cigarette packages, it’s rarely heeded. In fact, it’s quite the opposite. Past performance, or more specifically, good recent returns, are like a magnet for investors. They overwhelm the other factors that should go into a purchase decision such as quality of the people and firm, investment approach and fee.
If the label is to be believed and the past doesn’t predict the future, why does performance carry so much weight?
The main reason is that outstanding recent returns are hard to ignore. Fund managers who are riding high look smarter. Their words, body language and the suit they’re wearing oozes it. The fear of missing out is overwhelming.
To fight FOMO, my partner, Salman Ahmed, and I select and monitor fund managers using an analytical framework called the 7 Ps. We look at People, Parent (organization and ownership), Philosophy, Process, Price, Performance (long term) and Passion. The last one refers to the fact that I prefer to hire geeks who live and breathe the portfolio rather than portfolio managers who are more media-friendly and have extensive marketing duties.
It’s important to remember that active managers go through cycles just like the stock market. An excellent 10-year record will include three to six subpar years. This makes it tricky to use short-term returns as a decision criterion. The Ps approach, in my view, is a better predictor of future results, although it’s hardly foolproof.
In the institutional arena, pension and foundation committees use similar criteria, although if recent performance isn’t near the top of the charts, the other 6 Ps don’t usually win the day. Managers almost never get hired when they’re going through the down part of their performance cycle.
The pattern is the same when it comes to managers being fired. The decision is overwhelmingly based on recent returns. Managers who are performing well are rarely let go, even if a key person leaves, the firm gets sold and changes direction, or the decision-making process changes. But a poor five-year return is often enough for a committee to fire a manager and hire another who has done better over that period.
But is five years long enough? Disappointingly, the answer is, it depends. A performance drought may feel like it’s gone on forever, but what really matters is how the manager or fund has performed over a full cycle — i.e. good and bad markets.
Consider our current circumstance. We’re in a 10-year bull market that’s been fuelled by a few persistent themes. Interest rates have been low and/or declining. Debt markets have been strong. The U.S. stock market has consistently smoked the rest of the world. And growth stocks have had an extended period of superior performance compared to value stocks. It’s hard to assess how a manager or fund will do through all seasons when there hasn’t been a severe winter in a decade.
In my past life when I was working with pension clients, the best relationship I ever had was with a committee that selected our firm when we were going through a tough period. When I voiced surprise that we’d won the mandate, I was told they really liked the firm, the people and the long-term returns. They viewed the recent lull as a great opportunity to get in. By the time the paperwork was completed, and money invested, our performance was on an upswing and a lasting relationship had been established.
I’m not suggesting that you should avoid a manager or fund because the last few years have been good. Not at all. But you need to guard against the tendency to chase performance. Your odds of long-term success (all seasons) improve significantly if you have other good reasons for investing. Those other reasons will come in handy when the inevitable weak, ‘not-so-smart’ period hits.
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