Why Past Performance Does Not Equal Future Success

March 16, 2015

By and large, both investors and fund professionals rely heavily on past performance in their fund selection process. The problem is that past performance is of little use in identifying funds or managers who will deliver superior future performance relative to their peer group. Numerous studies have failed to unearth a significant positive correlation between past relative performance and future relative performance. The only correlation found has been the consistency of managers with very bad returns to continue to post bad returns in the future.

Our experience evaluating active managers leaves us less than surprised by the inability of winners to consistently repeat. Our research indicates that even skilled managers’ past success often sows the seeds of their future underperformance. There are a variety of reasons that we have identified as to why maintaining an investment edge is difficult:

  • Success results in asset growth. Asset growth may lead to declining flexibility, especially for smaller-cap managers, and result in a smaller universe of investable stocks. Success often leads to stardom and the temptation to leverage the marketability of the portfolio management team by launching other products. This may force the management team to manage other types of portfolios, reducing their focus on the original fund.
  • Team turnover. Success and “stardom” may lead the manager or key members of the team to move on to other firms/hedge funds or start their own. If key players leave a fund, the fund’s prior track record is basically worthless when evaluating the fund going forward.
  • Overconfidence. Great performance often leads to overconfidence that can result in analytical sloppiness and corners being cut, e.g., the manager may rely more on instinct or gut feel or mental short-cuts rather than doing all the difficult analytical work that contributed to their past success.

The fact that track records are not useful in predicting future relative performance is the basis on which index fund proponents conclude that low cost index funds are the better choice. But we disagree with the underlying premise. The fact that track records are not predictive is not tantamount to concluding that superior future performers can’t be identified in advance. It simply means that the track record does not provide sufficient information to do so. Our approach to fund research recognizes that past performance is useful only as a tool for screening funds to identify those that may be worthy of further research. Value added comes from identifying why a fund performed well in the past, determining if the portfolio management team has an identifiable edge and assessing whether the edge (if one exists) is sustainable.

 

 

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