Summary
- Past performance is not a good indicator of future results because is does not disentangle skill from luck.
- Active share has been shown to be a very useful indicator; managers whose portfolios differ substantially from their benchmarks tend to outperform.
- Research shows that a significant minority of active managers do outperform and that investors may be able to identify them with public information.
One of the most widely practiced rituals of the investment industry is discussing past performance. This habit, of individual and institutional investors alike, is facilitated by the widespread availability of performance numbers. Unfortunately, the performance derby that ensues from this orientation serves to distract attention away from issues that matter far more in regards to your welfare.
One of the best thinkers in the industry, Nassim Taleb, addressed the role of performance in response to the question of how to do the most good and the least harm in the investment industry. In the article "Controlled Burns" in the CFA Magazine, Taleb answered: "Try not to compete on the basis of performance but add qualitative elements to show responsibility in managing risks and consciousness of the need to really protect the client's portfolio rather than your own ... When you invest your client's money, you don't invest it just for performance but for robustness. That's what your clients want."
Taleb makes a strong case against using past performance in regards to the goal of robustness, but there is an even stronger one. Past performance doesn't even provide meaningful insight into future returns.
The verdict on past performance isn't new but it is one of many nuggets of investment insight that just hasn't diffused through to the investment public very efficiently. Indeed the evaluation of past performance has been studied fairly rigorously and the logic for its failure is straightforward. According to Mark T. Finn and Jonathan Finn, CFA, "The data problem can be thought of as analogous to an engineering concept called the signal to noise ratio ... The reality is that there is a tremendous amount of variability, or noise, in security and manager returns." [Just One Thing: Twelve of the World's Best Investors Reveal the One Strategy You Can't Overlook, edited by John Mauldin].
Michael J. Mauboussin spoke in similar terms of "signal and noise" in a presentation to the CFA Society of Baltimore about his book, The Success Equation. In it he said, "Outliers exist due to extreme skill and extreme luck combined." He added that, "Where there is luck, there is reversion to the mean." Mauboussin elaborates on his thesis "Seeking portfolio manager skill": "Results, and especially short-term results, cannot distinguish between a good process and a poor process because of the role of luck. So going directly to the results gives little indication about the quality of the decision-making process and the skill of the participant."
These assessments are not just theoretical, but are also corroborated by experience. Finn and Finn report that, "Studies have shown that even managers with the best long-term records commonly underperform the market 40 percent of the time, and it is not unusual for them to have periods of three to five years of sub-par performance." Nonetheless, despite strong evidence to the contrary, it is still common practice for consultants to put managers on watch after three years of underperforming the benchmark.
Mauboussin expands on the discussion by elaborating exactly why performance measures don't work. He explains, "The returns-based approach skips the two steps of reliability and validity and goes directly to the results. It doesn't pause to ask: what leads to excess returns? It just measures the outcome. This approach works in fields where skill determines results and luck is no big deal. For example, if you have five runners of disparate ability run a 100-yard dash, the outcome of the race is a highly reliable predictor of the next race. You don't need to know anything about the process because the result alone is proof of the difference in ability."
Insofar as our goal is to identify the characteristics of managers that have a high degree of skill and therefore the best chance of outperforming, we now have an appropriate analytical framework from which to make assessments. Mauboussin continues: "Now the discussion shifts a bit. The questions become: which measures of an active manager's portfolio reflect skill and therefore reliability? For example, a manager may be able to control the number of holdings, risk, turnover, and fees. Next, of the measures that are reliable, which are highly correlated with the ultimate objective of delivering excess returns? Are there measures that are both reliable and valid?"
The answer is a resounding, "YES!". More specifically, that measure is Active Share. This metric determines the degree to which a portfolio is different from its benchmark. The highest level is 100% and at 0%, the portfolio would be identical to the benchmark. In order to provide some reasonable thresholds, Mauboussin notes that, "Generally, an active share of 60 percent or less is considered to be closet indexing and active shares of 90 percent or more indicate managers who are truly picking stocks."
In a terrific study, "Active Share and Mutual Fund Performance" from the Financial Analysts Journal, Antti Petajisto sheds a great deal of light on active investment management by analyzing the performance of all-equity mutual funds categorized by the magnitude of active share. He found that, "The most active stock pickers [highest active share] outperformed their benchmark indices even after fees, whereas close indexers underperformed."
Managers with high active share have a better chance of outperforming for two predictable reasons. One is that they focus on "best ideas" which can meaningfully impact portfolio performance. The other is that they don't have a lot of overlap with benchmarks that could be replicated with low cost index funds. As Petajisto describes, "The problem is that closet indexers are very expensive relative to what they offer." Now investors have an objective measure to verify the stock picking intensity of their investment managers and therefore to better gauge the value of those services.
As effective as active share is in evaluating the skill of an investment manager, there are plenty of other measures that can help too. In a terrific review of academic literature on the subject, Robert C. Jones, CFA and Russ Wermers highlight a wide variety of useful characteristics in "Active management in mostly efficient markets" from the Financial Analysts Journal. In addition to being a great resource for manager evaluation criteria, the Jones and Wermers piece also provides a useful endorsement of the effort: "This survey of the literature on the value of active management shows that the average active manager does not outperform but that a significant minority of active managers do add value. Further, studies suggest that investors may be able to identify superior active managers (SAMs) in advance by using public information."
Warren Buffett once said, "There is so much that's false and nutty in modern investing practice ... If you just reduced the nonsense, that's a goal you should reasonably hope for." The bad news is that a large proportion of industry participants still focus on past performance like a bad habit. The good news is that you can "reduce the nonsense" by foregoing the distraction of past performance and instead focusing on other more indicative factors. The really good news is that such factors exist. Active share, in particular, is a powerful metric that is making significant headway with sophisticated investors. In short, changing the discussion about performance is one of the simple things you can do to level the playing field and shift the odds in your favor.
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