“Past performance does not guarantee future results.”
That disclaimer, or words to that effect, accompany most advertisements of investment performance. And yet, a great amount of ink, airtime, and mathematical gymnastics go into presenting past results to attract investors. Those numbers must have some value, mustn’t they?
The key to getting any worthwhile information out of a performance track record is not just recognizing that past performance often leads to future disappointment, but understanding why that is.
A whole new ballgame
Statistics are woven deeply into the fabric of American culture. Take baseball, for example. It is hard to get far into a discussion of the national pastime without citing statistics – batting averages, won-lost records, earned run average, etc.
Those stats don’t just give us yardsticks for evaluating past achievements, but for current players they give us a basis for what to expect they will do next season. If someone has hit .300 or better for the last eight seasons, we expect he will succeed at around that rate next season. If someone has never hit more than 10 home runs in six previous major league seasons, we can be pretty sure he won’t lead the league in homers next year.
It is not surprising that people bring a similar reliance on statistics to choosing investment products. Funds and managers are marketed on their track records, and consultants make their careers out of micro-analyzing reams of performance statistics. And yet, there’s that disclaimer....
The reason investment managers are required to make a disclaimer about the limitation of past performance is that when it comes to investment returns, history is a pretty poor guide. There are a few reasons for this
Market cycles. Some investments do better in bull markets, while others hold up well in bear markets. Unless you look at performance over a full range of rising and falling conditions, you may be getting a skewed view of an investment approach’s success. Unfortunately, investment products are rarely advertised showing complete market cycle performance. Seemingly tidy one, three, and five-year periods are commonly used instead. Since these are likely to be dominated by either bull or bear market conditions, the leading managers in those periods will often disappoint as soon as the cycle enters a new phase.
Style and sector rotation. Even beyond the rising and falling of the market as a whole, different investment styles and industry sectors rotate through different periods of leading or lagging the market. So, what can seem like manager brilliance is often just a product of having a style that was temporarily in favor.
Size constraints. The larger an investment product gets, the more difficult it becomes to get in and out of investment positions efficiently. Thus, a manager’s past success often sows the seeds for future difficulties – a hot performer attracts assets, and those additional assets steadily weigh the investment approach down until it is no longer sufficiently agile.
Personnel changes. Past numbers especially lose their relevance when key people responsible for the track record are no longer with the organization. Personnel turnover is common in the investment business, rendering many track records even less relevant.
The method behind the numbers
All of this poses a dilemma for entrepreneurs looking to diversify from their successful start-up into publicly traded stocks. In doing so, they are faced with going from a company they knew intimately well to a portfolio of holdings they cannot possibly know as well. If past performance of investment managers and funds is of limited use in choosing such products, what is there to go on?
To some extent, choosing an investment product should rely on some of the same judgements you would use in choosing whether to invest in a private venture. These include:
Strategy. Since new ventures don’t have a track record, entrepreneurs have to make decisions about their prospects based on a qualitative judgement of the underlying business strategy. Given that investment track records have limited use, the same approach should be taken in choosing investment products. Does the investment strategy offer a sound and repeatable reason for success?
Process. Understanding the discipline with which manager executes investment strategy is also vital. Experienced entrepreneurs have probably seen many examples of a decent business plan foiled by poor execution. That experience should be used to scrutinize the process by which an investment manager makes buy and sell decisions and monitors positions.
Corroboration. A performance track record may not tell the full story about how good an investment product is, but it can provide some corroboration as to how well an approach does what it is designed to do. For example, a supposedly defensive investment approach that is a leading performer in a bull market should not be looked at as the best of both worlds. That performance could be a warning sign that its defensive characteristics are not as advertised.
Entrepreneurs should understand better than most that sound judgement can do a lot more for a person’s success than statistics about the past. People who forged new ground in business rather than simply joining already-thriving concerns have experience with the fact that the future can be more than just an extrapolation of the past. After all, the relevant question for an investor is not about what has already happened; it’s about what is likely to happen next.
President & CEO of TIGER 21