Should you buy investments that have outperformed?
James Sellon, Co-Founder of MASECO, discusses in his recent article that although there are a myriad of factors taken into account by professional and non-professional investors when narrowing the odds of making a good investment decision, more weight is generally put on recent past performance as a guide to future performance. Within this article James poses the question 'should you buy investments that have outperformed?'.
As you read this article probably a million asset allocation conversations are happening. Clients are conversing with their wealth manager, consultants are speaking with their trustee, investment professionals are debating with investment professionals. All these conversations will probably have one common thread:
‘will moving from position/fund X to position/fund Y be a productive trade (i.e. make more money)’
Professional and non-professional investors alike review a myriad of factors when attempting to narrow the odds of making a good investment decision, but more weight is generally put on recent past performance as a guide to future outperformance.
No matter how often we are told that historical performance is not a reliable indicator of future performance, fiduciaries and investment consultants seem to ignore it. Doing the opposite (buying poor performers and selling strong performers) seems unthinkable and untenable – Investment Committees would have a challenge justifying such a strategy.
The last time I delved into the academic literature on this subject was in the wake of the Global Financial Crisis. Given we are in the wake of another crisis (albeit of an entirely different cause), I brushed off that literature.
I was intrigued to read Jason Tsu’s collaborative academic article published in The Journal of Portfolio Management - ‘Does Past Performance Matter in Investment Manager Selection’ . The question posed is:
“Could managers with better recent outperformance be more likely to underperform over the standard investment evaluation horizon? “
Could a contrarian strategy of investing in managers with poor recent performance, and firing those with strong recent performance, deliver better returns?
Empirical Results – Mind the (return) gap
Jason created buckets for Winners and Loser Strategies. The winner strategy allocated capital to those managers who had a strong three-year track record. The Loser Strategy – the opposite.
The results were quite astounding. Between 1994 and 2015 the Loser Strategy outperformed the Winner Strategy by over 2% per year!
So, what to do?
We believe the practice of investing with fund managers based on historical outperformance, and firing those that have done the opposite, is completely wrong.
The challenge is that the industry and investors are not set up for choosing underperforming managers and firing the ones that have outperformed.
The practical implication is that individual investors, fiduciaries, consultants and asset owners should focus on other factors beyond past performance when selecting managers. The world does mean revert – what goes down often goes back up and what goes up often goes back down.
Jason does shed some light on areas to focus and wider factors to consider, excluding past performance, that might have predictive power. Simply put, one should focus on the manager’s strategy and their ability to execute on their strategy.
As most of our clients know we focus on capturing various risk premia that are evidenced in the marketplace (size, value, profitability & momentum). Our time and effort is spent in assessing whether the managers we use are the best at being able to execute on their particular strategy. At the same time we have a robust framework in place to minimise the risk of suffering from the behavioural bias of buying past Winners and selling recent Losers.
Source:  Does Past Performance Matter in Investment Manager Selection, July 2017, Journal of Portfolio Management 43(4):33-43
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Use of information:
• Nothing in this document constitutes investment, tax or any other type of advice and should not be construed as such.
• The investments and strategy noted in this document may not be suitable for all investors and making available the information in this document is not a representation by MASECO that any investment strategy is suitable for any particular client.
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