Depending on what you want it to tell you, past performance can be either reliable or very unreliable. If you’re making investment decisions with the assumption that recent performance will continue, the measure is dangerously unreliable – as recent market volatility has demonstrated.
Yet, studying past performance can be a valuable exercise from the standpoint that reversion to the mean is a powerful dynamic, and the examination of past performance – especially over a longer period, spanning various market cycles – can help investors avoid costly mistakes.
Unfortunately, investment decisions are fueled too often by performance alone – hiring an active investment manager on the basis of solid past performance or terminating another because of recent poor performance. To be sure, hiring superior managers is critical to the long-term success of a portfolio. However, mistiming such decisions can limit the chances of success.
The performance of investment managers is cyclical and, as such, is subject to misinterpretation. In some periods, managers have been able to add value with an above-average success rate. In other periods, benchmarks have been incredibly difficult to beat and managers have lagged.
Investment style also plays an important role in determining a pattern of performance, even within the same asset class. If a manager’s investment style is out of favor in the marketplace, those headwinds will be difficult to overcome. Conversely, that style can easily come back into favor and provide a tailwind for much improved performance in the future.
Past performance, especially short-term, is the most readily available gauge for investment managers. But the convenience and widespread use of performance information should not be interpreted as a unanimous endorsement of its reliability. In fact, successful past short-term performance and future performance often have an inverse relationship. Surprisingly, our research found that investment managers who ranked in the lower quartiles over the past five years actually outperformed their higher-ranked peers over the subsequent five years, on average. Further, managers who ranked in the bottom half of their peer group universe provided a future excess return that was nearly 40 percent higher than that of an above-median manager.
Maximizing the return from investment managers requires the aptitude to select above-average managers and the fortitude to maintain a disciplined approach. Investors are encouraged to work with a professional financial advisor who has access to resources that can tell the whole story behind past performance numbers and give them an edge.
Tim Byrne, director of private wealth management research, products and services, and Aaron Reynolds, senior portfolio analyst, at Robert W. Baird & Co. Inc.
