How to use past performance in evaluating managers
- Despite its widespread use, past performance alone provides very little useful information regarding future performance
- This happens because both skill and luck are involved and past performance does not disentangle those effects
- Too much reliance on past performance can be misleading because even poor managers can outperform for significant periods of time and good managers can underperform
- The mistake of focusing on past performance is made frequently by both individuals and institutions
- In addition to being ineffective, focusing on past performance also distracts away from the most important objectives of money management
"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."
"Outliers exist due to extreme skill and extreme luck combined."
"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."
"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."
"Goyal and Wahal (2008) looked at the hiring and firing decisions of institutional sponsors and found that managers whom institutions hire do not outperform managers they fire."
Robert C. Jones, CFA, and Russ Wermers, "Active Management in Mostly Efficient Markets", Financial Analysts Journal, November/December 2011
"Let's say you're looking for ways to do the most good and the least harm in the investment industry. How would you do that?
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.
Also, consider the model you use for compensation. You should have disincentives for losing money. The ethics of the business should not be based on performance but on responsibility. When you invest your client's money, you don't invest it just for performance but for robustness. That's what your clients want."
Rhea Wessel interview of Nassim Taleb, "Controlled Burn", CFA Institute Magazine, Sept/Oct 2013
"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 do identify superior active managers (SAMs) in advance by using public information."
"Although the average actively managed mutual fund has underperformed its benchmark index, both the type and the degree of active management matter considerably for performance ... I found that the most active stock pickers have been able to add value for their investors ."
- A significant body of research indicates past performance is not a useful indicator of future performance
- Further, undue emphasis on past performance can distract from the more meaningful goal of robustness
- Research also suggests that other pieces of publicly available information may be helpful in evaluating active managers
- Active Share is a powerful metric for evaluating managers that is increasingly being used by sophisticated investors