Investing beauty contest leads to ugly returns

It’s hard to imagine an investment world where the best-performing managers were fired and replaced by the poorest performers. Such a scenario would seem both illogical and unfair; however, a new study suggests it might just end up delivering the goods for investors.

That's according to the US authors of a new paper, The Harm in Selecting Funds That Have Recently Outperformed.

Academics have long been sceptical of the notion that investor skill can be measured by recent performance, but the study acknowledges that the “beauty contest process” is a reality in the investment world, with trillions of dollars migrating in and out of funds on the basis of their recent three-year performance.

Investment consultants will admit past performance continues to be the most important criterion for selecting managers, and one can understand why. After all, past outperformance may be a product of luck or skill. If skill is the reason, then picking the best performers will generate better returns for investors. If it’s a product of luck, then it will have no impact either way, and no harm is done.

That’s the theory anyway. However, what if the best performers go on to underperform in future years? In such a scenario, it would pay to invest in the poorest performers and fire the top performers.

This “may seem daffy”, the study acknowledges, but “there is method in the madness”. Many fund managers will follow a particular style; some will load their portfolio with small-cap stocks, others will buy unloved value stocks, while others may invest in high-flying momentum stocks. Many of these investment factors are mean-reverting, with years of outperformance all too often followed by periods of underperformance. Accordingly, a good recent track record may be an indicator of below-par returns in the future. Many people take a contrarian approach to buying stocks, so why not take a similarly contrarian approach to manager selection?

Study

To investigate, the study examined fund performance over the 1994-2015 period. Expensive high-cost funds were eliminated from the sample, on the grounds that they would inevitably be persistent underperformers. Three investing strategies were then tested – the “winner strategy”, whereby money is invested in the decile of funds that have delivered the best returns over the previous 36 months (generally, these funds would be rated highly and recommended by financial advisers to their clients); the “median strategy”, which consisted of middle-ranking funds over the previous three years; and the “loser strategy”, a collection of the recent poorest performers, the type of funds that are typically eliminated from client portfolios by financial advisers. At the end of each three-year period, the process was repeated, so that the separate portfolios always consisted of the top, middle and bottom-performing funds.

The results were stark. The winner strategy delivered annual returns of 8 per cent, well below both the median strategy (9.8 per cent) and the loser strategy (10.4 per cent). To put that in perspective, a €10,000 investment compounding at 8 per cent annually would be worth €46,609 after 20 years, compared to a lump sum of €72,340 for one returning 10.4 per cent annually.

Returns over 24-month periods – that is, the top, middle and bottom-performing funds over the previous two years –were also analysed. Results were little changed: the median portfolio trumped the winner strategy, while the loser strategy delivered better returns than the median strategy.

Clearly, the notion that recent returns are an accurate reflection of skill does not hold up. Of course, some managers are skilled, and will deliver excellent returns over the long term. A portfolio consisting of the top quartile of funds would have done very nicely over the 1994-2015 period, returning 12.3 per cent annually. What if you were to further screen these managers, based on recent performance? Would that help or hinder your performance?

The latter is true; returns fell to 10.6 per cent when you picked the most recent winners. In contrast, picking the most recent losers would have juiced returns further, to 13.5 per cent. In other words, even if you get lucky and are presented with a select list of top fund managers, “using recent outperformance to further screen managers is a harmful practice”, one that will “meaningfully detract value”.

Implications

The findings have very real implications for investors. Firstly, they help explain the so-called behaviour gap, the well-established tendency for investors to underperform the funds they are invested in. One might read, for example, of a fund that has delivered stellar returns, but it’s very rare that the average investor in that fund fully shares in its success. Even the very best fund managers will go through years of underperformance. Unfortunately, investors and advisers tend to mistake such periods as evidence that the manager has lost his touch; consequently, they tend to bail out after period of underperformance and invest in the latest hot fund.

Secondly, it’s clearly erroneous to think that superior performance over a relatively short period (three years) is indicative of fund manager skill. Rather, it indicates that any outperformance or underperformance is likely due to a fund’s exposure to a particular investment approach. As mentioned earlier, exposure to a certain subset of stocks may work well in one environment only to subsequently fall out of fashion. “When we fire a manager who has underperformed recently by 3 per cent per annum, are we really eliminating a source of bad future performance from our portfolio?” the authors ask. “Or have we just fired someone with an investment style that is poised to mean-revert?”

Thirdly, picking recent outperformers and dumping underperforming managers is likely to prove to be a costly mistake. If you’re thinking about investing in a particular fund because it has trumped its rivals in recent years, think again. The data is clear: “If the results are accepted at face value, then if past performance is used at all for hiring and firing managers it is the best performing managers that should be replaced with those who have performed more poorly.”

Picking winners

As the authors acknowledge, firing seemingly successful managers and replacing them with poor performers is “not likely to gain widespread acceptance”. Accordingly, they recommend investors check out the “theoretical soundness” of the investment thesis underlying a fund’s portfolio strategy. That’s easier said than done. Similarly, other “objective characteristics that are indicative of manager quality” are not exactly on the radar of most ordinary investors. Such characteristics include a high active share (that is, a portfolio that is very different to benchmark indices), the presence of performance-linked bonuses, a high level of fund manager ownership, and having PhDs in key portfolio roles.

If that’s too much work – and for most investors, it will be – the best approach may be to buy simple index funds that track markets rather than pouring money into hot funds. Alternatively, it may be worth assembling a portfolio of exchange-traded funds (ETFs) that give investors exposure to potential sources of outperformance. Historically, investors who focused on, for example, value stocks, momentum stocks, small-cap stocks and low-volatility stocks enjoyed market-beating returns.

It’s much easier, of course, to play the beauty contest game and simply pick the most successful funds of recent years. Such an approach is, as the study notes, “intuitive and thus defensible to investors”. However, it also “turns out to be 180 degrees wrong”.