Research Affiliates: Performance Measurement – How To Do It If We Must

March 20, 2018

Key Points

  • Investment professionals can overdo performance measurement simply because technology makes it so easy and it seems a worthwhile task to constantly gauge if clients are on the path to meeting their long-term financial goals.
  • Too often, however, “doing something” based on short-term performance measurement can degrade the long-term performance potential of a portfolio by chasing recent winners.
  • If we must regularly assess performance, let’s focus on performance relative to expectation distributions, such as a strategy’s expected tracking error of returns relative to its benchmark.

In the last installment of the advisor series, our colleagues discussed how financial advisors can better serve their clients by shifting their due diligence efforts to identifying more reliable product designs in smart beta. In this article, we discuss why the investment industry is so obsessed with short-term performance evaluation and how investors can steer clear of the pitfalls arising from measuring and chasing returns.

If you’ve been a regular reader of our article series dedicated to the concerns of advisors, we hope you’ve found our ideas helpful in finding new ways to maximize your clients’ chances of achieving their financial goals. We started with a model of return and risk expectations (check!), added adequate diversification (check!), and reviewed product design and implementation considerations (check!). Next, it seems natural to closely monitor how investments perform over time, right? Well, not so fast. Before we engage in the common practice of performance assessment, let’s take a deep breath and recognize that, in many cases, we’d be better off not engaging in regularly scheduled performance measurement. Of course, that’s much easier said than done. And since we almost certainly must measure performance, we recommend doing so within a framework that acknowledges short-term noise and encourages investors to stay the course as they pursue long-term investment returns that are less random and more predictable.

The Things We Do
Most investment professionals—financial advisors included—seem to devote nearly as much time to performance measurement on the job, as we humans seem to spend on social media, off the job, these days. Sadly, we appear to be doing far too much of both. In the case of performance measurement, technology simply makes it so easy to run the numbers.1 Keeping close tabs on portfolio performance must be “proof” we are acting as responsible fiduciaries and investors, and is a guide to us in making superior decisions. Unfortunately, the evidence suggests otherwise. Just because we can do something, and have been doing it often in the past, doesn't make it a worthwhile activity.2 Instead, we might all be better served by taking a step back from the endless noise and step off the treadmill of “doing” to ask ourselves a few questions: Why do we spend so much time as a profession measuring and comparing the recent performance of securities, managers, and investment styles? Does this practice add value over the long run?

I’ve taken the unconventional step of deleting my Facebook and Twitter accounts over the last year. I can’t say that I miss either. Now, I’m not advocating you should fully unplug and stop looking at performance. I’m simply reflecting what we believe at Research Affiliates: that investors need to recognize a) the large sunk costs that come from obsessively monitoring performance and b) the natural (and dangerous) consequences that emerge from this activity. Namely, costly mistakes arise when we react to short-term performance assessments by piling into the recently brilliantly performing strategies and selling the performance laggards. In short, traditional performance measurement can be far worse than a neutral time sink akin to playing Candy Crush. It can actually detract from a client’s realized returns when the activity of measuring performance turns into chasing performance. The natural human instinct of “Don’t just sit there, do something!” encourages us to favor investments that have done well recently and to pull away from recent poor performers—just when predictable long-run mean reversion lies ahead.

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