Swedroe: Past Performance Deceives

November 10, 2017

Despite most investors’ belief that past performance matters, a large body of academic research has found little-to-no evidence that more managers than would be randomly expected persistently outperform the market on a risk-adjusted basis.

While this outcome is disheartening to those engaged in manager selection, it shouldn’t be at all surprising. As my co-author Andrew Berkin and I explain in our book, “The Incredible Shrinking Alpha,” there is fierce competition among highly skilled managers that makes markets highly, though not perfectly, efficient. The result of this fierce competition is that there are few “free lunches” to be had—and certainly not enough of them after taking into account the costs of active management.

In addition, as Jonathan Berk pointed out in his paper, “Five Myths of Active Portfolio Management,” rational active managers extract what is referred to as the “economic rent” for their services, given that alpha skill is the scarce resource, while capital is plentiful.

While the common practice of hiring managers with superior recent performance and firing managers with poor recent performance may seem logical, and doing the opposite would seem counterintuitive, the evidence shows past performance is not predictive.

Yet investors still allocate about twice as much capital to active strategies as they do to passive ones. For retail investors, capital flows follow performance over relatively the short period of six to 12 months.

The research also shows that trillions of dollars in pension plan assets are delegated to actively managed funds through a “beauty contest” process that focuses substantially on performance over the slightly longer period of the past several years.

Sometimes past performance is measured against market benchmarks such as the S&P 500. In other cases, a more sophisticated factor analysis ensures performance is measured against appropriate risk-adjusted benchmarks.

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Bradford Cornell, Jason Hsu and David Nanigian contribute to the literature on this topic with the study “Does Past Performance Matter in Investment Manager Selection?”, which was published in the Summer 2017 issue of the Journal of Portfolio Management.

Specifically, the authors examined “whether selecting managers based on recent simple outperformance against the stated benchmark (the dominant manager selection heuristic) can lead to subsequent simple outperformance against the benchmark (the desired outcome for most institutional investors).”

To simulate the impact of the popular manager selection heuristic, they compared the performance of hypothetical pension portfolios that follow policies that mandate investing in products based on recent benchmark-adjusted returns.

The authors start with the commonly employed “winner strategy,” defined as follows: At the beginning of each three-year period, investors purchase equal positions in products that rank in the top decile of benchmark-adjusted returns. At the end of three years, monies are reallocated to a new portfolio that is once again equal-weighted among the top-decile performers.

They then compared the investment results of their winner strategy with those of a “median strategy,” whose three-year asset allocation policy is to invest in products that rank between the 45th and 55th%ile of benchmark-adjusted returns.


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