Responsible Investment Forum with Steve Schueth

Responsible Investment Forum with Steve Schueth

The temptation is overwhelming. We are bombarded by impressive statistics every time we open the financial pages or tune in to cable news. Unfortunately, numerous studies have demonstrated how harmful chasing investment performance can be. One of the better-known evaluations was conducted a few years ago by Morningstar (a mutual fund rating firm) and showed that investor returns were generally many times lower than the reported return of the funds. Why? Primarily because once a fund performs well, fund companies market the good performance and lots of money flows in. Mediocre or worse performance often follows.

Socially conscious (and unconscious) investors who buy into the previous year's best performers are often buying high and selling low—exactly the opposite of what anyone would want to do. As First Affirmative's Chief Investment Officer, Kevin O'Keefe, explains, there is no substitute for gaining an in-depth understanding of the sustainability of a manager's performance record. What you don't know can hurt you—a lot.

Past Performance Often a Poor Predictor of Future Results
By Kevin O’Keefe, CIMA, AIF

Investors tend to overemphasize past performance when selecting mutual funds and managed accounts. But how useful is past performance really when trying to identify funds or managers who are likely to produce superior performance in the future?

The only meaningful statistical correlation between past and future performance is reflected in the fact that managers who generate very poor relative returns tend to continue to do so. No one has ever found a statistically significant link between good historical performance and superior future performance.

Why then do so many investors place so much importance on information that does not really improve their chances for success? Perhaps it’s because many investors don’t know that past performance is not a good predictor of future success. Or maybe it’s because, despite requisite disclaimers, the financial services industry encourages performance chasing and continuously supports the fallacy that past performance should be used as the basis for making successful investment decisions.

Admittedly, most investors don't know what else to base their decisions on. Historical performance numbers are easy to get and easy to understand. Research that goes beyond past performance requires time, experience, and knowing what questions to ask. It also involves access to information that most investors cannot easily get.

There will always be top-performing funds and managers whose track records have been a result of luck rather than skill. But luck eventually runs out, and the portfolios of less skillful managers will underperform. "All right," you say. "But isn’t it reasonable to expect that some of the best performing managers are also the most skilled? And, therefore, shouldn't funds with the best track records continue to outperform?"

Not necessarily. It’s very difficult for a manager to maintain an investment performance advantage. A manager’s investment success usually results in growth of assets under management, which may affect the manager’s flexibility. The manager may be forced to own more stocks to accommodate the burgeoning portfolio. This dilutes their best ideas and also leads to a portfolio that begins to resemble an index or "the market." As the size of the portfolio continues to expand, the manager may have to buy more and more of a company's outstanding shares, which can increase the portfolio’s risk. It is not unusual for very large mutual funds to become victims of their own success.

Mutual fund companies that have one or more top-performing funds are often faced with the choice between doing what is in the best interest of shareholders and doing what is in the best interest of the fund company. It is common for a star manager to be asked to manage other portfolios, which tends to reduce his/her ability to focus on the original fund. As successful managers become spread too thin, they often hire more analysts and delegate more responsibilities. New team members may be less skilled or experienced than the original team, which can lead to a dilution of the stock selection expertise.

Fame and fortune may entice a star manager or analyst to jump to another firm or, as is increasingly common, to start their own hedge fund. If a key person departs, the fund’s prior track record is almost totally meaningless.

Another troubling effect of investment success is hubris or overconfidence. Managers are human, and when praise comes their way, they—just like any of us—can start believing their own press clippings. They can lose their ability to remain critical and objective. They can become overly attached to sectors or to securities that contributed significantly to their past success. Overconfidence can also cause a manager to underestimate the risk of being wrong.

The fact that historical performance is not a good predictor of future results does not mean that it is impossible to identify superior managers in advance. It simply means that past performance does not, in and of itself, provide enough information. Past performance is useful only in the context of other information about the manager’s process, such as:
  • The reasons why a fund or manager performed as it did;
  • Whether the management team brings a skill-set that provides an identifiable advantage;
  • Whether the advantage that might have produced superior past performance is still present; and
  • Whether current market conditions are likely to neutralize the manager’s critical advantage.

This kind of information cannot be gleaned from a fund’s track record. Such analysis requires ongoing communication with managers and their teams. Investment success, whether you invest on your own or in concert with a trusted professional advisor, requires knowledge, discipline, and patience.

You didn’t really think that all you ever needed to know was where to find a list of last year’s top managers, did you?


R. Kevin O’Keefe CIMA®, AIF® is Chief Investment Officer of First Affirmative Financial Network, LLC. He is responsible for due diligence and monitoring of mutual funds and separate account managers, and leads First Affirmative’s Institutional Consulting Services Group.

Steven J. Schueth is president of First Affirmative Financial Network, LLC. An independent investment advisory firm registered with the SEC, First Affirmative specializes in serving socially conscious individual and institutional investors nationwide. A former director and spokesperson for the Social Investment Forum, Schueth lives in Boulder, Colorado.