"Don't chase performance" is one of the most common financial warnings you'll hear from professionals.
Chances are you've heard it (or something like it) yourself. Don't be lured by "hot" stocks, or jump in and out of investments. Instead, stick to your investment discipline, be patient, and let time work for you.
Despite this, performance-chasing continues to happen. Investors still pile into stocks, funds, and sectors that have seen strong performance. And it's not just the inexperienced; high net-worth investors and institutional managers do it too.
Psychologically, performance-chasing is based on a simple assumption: the past is a good indicator of the future. If there's a strong correlation between the past and the future, then moving into investments that have been performing well is a perfectly rational decision.
On the other hand, if the past is not a good indication of the future – or if the correlation between the past and the future isn't as strong as we assume – then the reverse is true and performance-chasing makes no sense.
So which is it? Recently, I came across two research papers that put some hard numbers to the behaviour of performance chasing, and present a pretty compelling argument against it.
The first, by global investment consultants Segal RogersCasey, examined managers within nine equity and three fixed-income categories to better understand how likely it was for top-performing managers in a given asset group to stay top-performing managers.
The managers of each pool were ranked into quartiles based on their performance in two five-year investment periods: (a) from January 2004 to December 2008, and (b) from January 2009 to December 2013. The goal was to track how many of the top managers kept their ranking from period one to period two, and how many bottom-quartile managers were able to rise to the top.
The two charts below show you highlights of the survey for three main U.S. asset classes often used within wealth management.
As you can see, winners become losers and losers become winners. However, I was surprised at how difficult it really is for top-performing managers to maintain their status, particularly on the fixed-income side.
The other study was authored by U.S. ETF giant Vanguard, which looked at the histories of more than 3,500 equity mutual funds in order to compare a basic buy and hold strategy to a frequent-trading strategy that simulated the effect of performance chasing.
The study looked at three-year rolling return performance between the years 2004 and 2014, across nine equity groupings (this is roughly in-line with the time the average fund investor holds an equity mutual fund). The simulation also tracked the Sharpe ratio of the average fund in the category, a measure of risk-adjusted return.
The "rules" of the buy and hold were relatively simple: the simulation invested in any fund, and held it to the end of the time period. If the fund was discontinued, the simulation simply reinvested its money into the median-performing fund within the grouping.
For the performance-chasing portfolio, the simulation invested in any fund with an above-average three-year annualized return. If that fund turned in a below-average performance for the next three-year rolling period, that fund was sold and the simulation re-invested the proceeds in equal amounts into in the top twenty funds in the asset grouping.
At the end of the day, the simulation produced a total of more than 40 million return paths – a pretty good yardstick for measuring whether performance-chasing or buy-and-hold is the more sensible strategy.
The chart above illustrates that buy and hold was the clear winner, beating performance-chasing in all nine style boxes. Note the size of the performance gap between the two strategies.
The Sharpe ratio was better (i.e., higher) for each of the buy and hold portfolios, meaning there was less volatility along with better returns. Talk about having your cake and eating it too!
Click on image to enlarge
One interesting point: the Vanguard simulation ignored the impact of transaction costs or taxes. These wouldn't have made much difference to the buy and hold portfolio, but to the performance chasing portfolio, they would have produced a notable drag on returns, so the difference between the two would have been even greater.
What are we to make of these studies? To me, it's very clear: there is very little sense in chasing performance. Instead, it makes sense to "pick from the penalty box" if I could borrow a metaphor from my favourite sport. Buying a manager with a good (but not fantastic) longer-term performance record who has dropped out of favour over the past two to three years is the sweet spot. To put it in in hockey parlance, "taking a shot from right outside the crease, where most goals are scored".
This is the approach we take in our practice: "buy cheap and hold." That is, buy excellent managers after they have underperformed over the past one to three years, and hold them. Many times we add on the dips. As the Segal RogersCasey study suggests, those are the managers who have a higher probability of rotating back into outperformance again.
Why do investors do the opposite? In my experience, investors very much want to invest with confidence. And for many investors, confidence comes from recent track records, particularly when those track records have been celebrated or awarded or written up in glowing terms in the investment press. It takes great courage to ignore this kind of buzz and instead look for the hidden gems, but that's the reality of what every great investor does.
Thane Stenner is founder of StennerZohny Investment Partners within Richardson GMP Ltd., as well as Portfolio Manager and Director, Wealth Management. Thane is also Managing Director for TIGER 21 Canada. He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)'. (www.stennerinzohny.com) The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.