The (Un)Reliability of Past Performance - Dec. 2011
The (Un)Reliability of Past Performance The longer your view, the better your perspective By Baird’s Advisory Services Research We all know the old adage: past performance is not indicative of future results. However, this bit of wisdom typically hides in the fine print of disclosures even though it would likely serve investors better riding the masthead of an investment prospectus.If you’re making investment In this paper, we will explain how making investment decisions baseddecisions with the assumption on recent performance – even though this is the information most easilythat recent performance will available to investors – can be extremely counterproductive. It is ourcontinue, that measure is experience that more informed investment selections usually result fromdangerously unreliable – an analysis of less conveniently attained information. In the followingas recent market volatility has pages, we will offer some perspective on the valuable role past performanceamply demonstrated. can play when used in conjunction with a deeper analysis of various quantitative and qualitative factors. Understanding the Pattern of Active Manager Performance Depending on what you want it to tell you, past performance can be either reliable or very unreliable. If you’re making investment decisions with the assumption that recent performance will continue, the measure is dangerously unreliable – as recent market volatility has amply demonstrated. Yet, studying past performance can be a valuable exercise from the standpoint that reversion to the mean is a powerful dynamic, and the examination of past performance over a longer period spanning various market cycles can help investors avoid making costly mistakes. All too often, though, we see that investment decisions are fueled by performance alone – hiring an investment manager on the basis of solid past performance or terminating another because of recent poor performance. To be sure, hiring superior investment managers is critical to the long-term success of a portfolio. However, mistiming such decisions can be detrimental and limit the chances of success.
The Cyclicality of Active astonishing 82% of managers Manager Performance outperformed the benchmark. Even The performance of active investment though large-cap core is used in this managers is cyclical and, as such, is example, a similar pattern exists in all subject to misinterpretation. Financial asset classes. Advisors are often asked, “Should I At the individual portfolio level, utilize active or passive managers?” manager performance is also cyclical and the answer is, “It depends.” One for a variety of reasons. Investment reason the active-passive debate rages style plays an important role in on is the notion that performance of determining a pattern of performance, active managers varies from period to even within the same asset class. For period. In some periods, active example, a manager utilizing a deep managers have been able to add value value versus a relative value strategy with an above-average success rate. In may ebb and flow during different other periods, benchmarks have been periods. Market cap may also affect incredibly difficult to beat and active returns: a mega-cap portfolio will managers have lagged. perform differently than another that Graph A displays the calendar year has greater breadth and includes performance of large-cap core mutual companies with lower market fund managers relative to the S&P capitalizations. Certainly, the list of 500 Index.1 During the late ’90s, reasons why two portfolios perform the S&P 500 was difficult to beat. differently can be quite extensive. For example, in 1998 76% of active However, of utmost importance is theFigure 1: Performance Cyclicality - Managers Success Versus the Benchmark managers underperformed. Conversely, realization that portfolio performance in the early 2000s active managers is not always a direct extension of a fared much better. In 2000, an manager’s skill. If a manager’s GRAPH A: Performance Cyclicality – Managers’ Success versus the Benchmark Large-Cap Core Managers versus S&P 500 Index 100% 18% 21% 80% 30% 30% 37% 33% 42% 39% 50% 48% 49% % of Managers 54% 60% 68% 76% 40% 82% 79% 70% 70% 63% 67% 58% 61% 20% 46% 50% 52% 51% 32% 24% 0% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 % Outperform % Underperform Source: Morningstar Direct, S&P 500 Index, Baird Analysis. All performance is net of the mutual fund expense ratio. -2-
investment style is out of favor in the After recording thousands of marketplace, those headwinds will be observations a clear pattern emerged. difficult to overcome. Nevertheless, For example, in 1-year periods when that style can easily come back into the benchmarks were down 20% or favor and provide a tailwind for much more, the average manager improved performance in the future. outperformed by 165 basis points In aggregate, the magnitude of the (bps). (Note that one basis point market’s returns affects the fate of equals 0.01%.) On the other hand,Of utmost importance is the active managers, particularly at the when the benchmarks rose 20% orrealization that portfolio extremes. In general, active managers more, managers were not able toperformance is not always a direct tend to perform best in adverse market provide much excess return, especiallyextension of a manager’s skill. conditions and struggle in strong bull when incorporating investmentIf a manager’s investment style is markets. Graph B displays the median management fees. Among otherout of favor in the marketplace, manager’s over- or under-performance factors shaping this pattern, athose headwinds will be difficult in various 1-year periods, sorted by manager’s decision to hold cash in ato overcome. positive and negative market periods portfolio will provide a cushion in and measured across all nine domestic challenging markets, but that cash equity asset classes for the past position also serves as an anchor in 20 years ending September 2011.2 rising markets. Another factor at playGRAPH B: is that many managers have a high- quality bias and avoid stocks that soarMedian Excess Return in Various Market Environments 250 during low-quality rallies. 200 165 The (Un)Reliability of 150 120 110 Past PerformanceMedian Manager Excess Return (bps) 100 Past performance, especially short- 50 30 term, is the most widely publicized 0 and readily available gauge for active (50) managers. Performance is cited in (70) newspapers and is the primary (100) (150) underlying component used by major rating agencies of investment (200) (210) managers. Oftentimes little qualitative (250) >20% 20% to 10% 10% to 0% 0% to 10% 10% to 20% >20% information is available, such as investment philosophy or personnel Negative Market Periods (1-Yr % Return) Positive Market Periods (1-Yr % Return) changes. But the convenience and widespread use of performanceSource: Morningstar Direct, Baird Analysis. All performance is net of the mutual fund expense ratio. information should not be interpretedFor the 20-year period ending September 30, 2011. as a unanimous endorsement of its reliability. In fact, we’ve found evidence that suggests successful past short-term performance and future performance often have an inverse relationship. -3-
Graph C illustrates this concept. on average. Further, managers that The chart summarizes the 5-year ranked in the bottom half of their return of separately managedFigure 1: Performance Cyclicality - Managers Success Versus the Benchmark peer group universe provided a accounts from all nine domestic future excess return that was nearly equity asset classes over the 20-year double that of an above-median period ending September 2011.3 manager. These results help to To eliminate end-period bias, rolling confirm the notion of “reversion 5-year windows were examined. to the mean” and signal why it is In total, more than 30,000 dangerous to place too much observations were analyzed. emphasis on recent performance. GRAPH C: This concept of manager cyclicality, Past Performance versus Future Performance – An Inverse Relationship or reversion to the mean, may be easy to understand, but it is often a 200 hard concept to embrace in practice. Subsequent 5-Yr Excess Return (bps) 180 Behavioral finance suggests that it is 190 160 common to extrapolate a successful 140 150 track record into the future. Also, 120 100 it can be very difficult to make an 80 100 100 investment with a manager when 60 80 they are struggling because the 40 60 20 assumption is frequently made that 0 the manager is ineffective and prone Top 2nd 3rd Bottom Above- Below - to future underperformance. Quartile Quartile Quartile Quartile Median Median Anecdotally, we have seen evidence Previous 5-Yr Peer Group Ranking that past performance drives asset Source: Morningstar Direct, Baird Analysis. All performance is net of the mutual fund expense ratio. flows. Additionally, chasing these For the 20-year period ending September 30, 2011. returns often has an adverse impact on investors. We previously explored Managers were grouped based on this topic in the Baird white paper, their peer group ranking for the “The Truth About Top-Performing previous 5-year period, and then Money Managers,” where we their excess return was calculated for analyzed equity mutual funds that the subsequent 5-year period. bested their respective benchmarks Surprisingly, those managers that over long time periods. We consider had ranked in the lower quartiles these fund managers to be both over the past 5 years actually well-established and successful. Using outperformed their higher-ranked mutual fund data as a proxy for retail peers over the subsequent 5 years, investors, positive asset flows -4-
The Due Diligence Process generally follow above-average investors’ decisions can be quite How professionals choose and performance, and asset outflows harmful to long-term results. For monitor money managers follow a streak of poor performance example, over the past 5 years ending (see Graph D left side).4 However, September 2011, the “Investor Return” When choosing money managers, those same funds that experienced was less than the average fund return in it’s clear that past performance asset outflows subsequently out- all nine domestic equity asset classes. doesn’t tell the full story. The process of identifying quality performed by a fairly wide margin, on average (see Graph D right side).5 How to Avoid Costly managers and then monitoring Investment Decisions their performance over time is Morningstar, a leading mutual fund known as due diligence. In the research firm, provides an insightful In our opinion, maximizing the return legal world, due diligence refers calculation called the “Investor from investment managers requires a to the care a reasonable person Return.” This figure essentially captures combination of the aptitude to select should take before entering into the return of the average mutual fund above-average managers and the an agreement. In the investment investor after accounting for asset fortitude to maintain a disciplined management world, it refers to inflows and outflows, implicitly approach. Understanding, analyzing the deep investigation of a money measuring the effectiveness of buy and and monitoring the many investment manager that takes place before, sell decisions. This differs from the options available to our clients is a during and after that manager is stated return of the actual mutual fund, daunting task that requires that Baird recommended to a client. which assumes a buy and hold strategy. adhere to strict due diligence criteria At Baird, a team of analysts When evaluating the difference conducted by full-time portfolio conducts investment manager between these two sets of returns we analysts. Our goal is not to hire those due diligence. Their goal can begin to measure the impact of managers that have already done well, is to minimize the risk of investors’ timing decisions. What we it is to identify those that present the underperformance by gaining discovered is that the timing of most best prospects for future success. (continued) GRAPH D: Investor’s Folly – Buying High and Selling Low Average Net Mutual Fund Flows Average 3-Yr Annualized Excess Return in the 12 Months After Up/Downgrade of Mutual Fund After Up/Downgrade Mean 3-Yr Annualized Excess Return per Fund 350 3.0% 330 300 250 2.5% Median Net Flow per Fund 200 2.1% 150 2.0% 100 1.7% 50 1.5% 0 50 1.0% 100 150 0.5% 200 250 0.0% 300 (260) 4-Star to 5-Star Upgrade 2-Star to 1-Star Downgrade 4-Star to 5-Star Upgrade 2-Star to 1-Star DowngradeSource: Morningstar; Zephyr; Baird analysis. For the 10-year period ending December 2010. -5-
(continued from previous page) Our experience suggests that the following investment guidelines will benefit investors:a full understanding of the storybehind the numbers. The process • Understand that past performance is exactly that. It has already been earnedis continuous with equal effort and the same results are unlikely to continue in perpetuity. However,applied to manager selection and recognizing patterns of performance (how a manager does in variousongoing manager evaluation. environments) is important.It includes these steps: • Understanding how a manager achieved performance is as important as the1. Initial manager screening performance itself. Baird spends considerable time determining what element using a proprietary, multi-factor drives a manager’s success – people, investment process or even luck. model that encompasses 16 • Be skeptical about hiring after a peak performance period. Baird evaluates different factors scored over managers over many holding periods, not just the most recent. A manager various times periods that is competitive over many periods is more attractive than one that looks2. Preliminary and detailed portfolio strong because of recent outperformance. Not every manager follows good analysis, which requires weeks performance with bad, but reversion to the mean can be a powerful force and of research and numerous is something to be aware of. conversations with the • It often pays to be contrarian. As the saying goes, “the time of maximum prospective money manager pessimism is the best time to buy.” If nothing has changed with your3. On-site visits, which often lead investment manager, the performance may be cyclical and poised to rebound. to important observations Consider allocating more to an underperforming manager, much like you that cannot be garnered over would allocate to an asset class during re-balancing. the phone • An investor’s biggest folly is to buy high and sell low. Yet, we see clear evidence4. Written investment thesis that of this in the marketplace. Don’t be quick to terminate a manager if the consolidates all information underperformance is related to style and not skill – sometimes exercising gathered in the prior steps to patience is the best option. answer the question, “Why should • Set a rebalancing schedule. This will help to automate the countercyclical clients invest with this manager?” process of adding to those that are struggling and skimming from those that5. Committee approvals to ensure full are performing well. agreement that the manager is • Work with a professional Financial Advisor who has access to due diligence an acceptable investment option resources. The qualitative and quantitative story behind the past performance6. Ongoing due diligence including numbers is what can give investors an edge. periodic, on-site visits and frequent dialogue with managers is Investors should consider the investment objectives, risks, charges and expenses conducted to access consistency. of a fund carefully before investing. This and other information is found in theAlthough it is easy for investors to prospectus. For a prospectus, contact your Baird Financial Advisor. Please readaccess historical performance data, the prospectus carefully before investing.deeper information becomes muchmore difficult to uncover. A robustdue diligence process can bridgethat gap. Understanding the driversof performance can significantlyimprove our chances of identifyinghigh-performing managers. -6-