In the active fund management industry, there is no better sign of investment insight than to overcome the odds and produce excess returns with unfailing regularity. This notion is bogus because patterns of consistent outperformance are exactly what one would expect to see if results were entirely random. This measure alone tells us nothing and believing in it would lead investors to an array of investing mistakes.
The careers of most star fund managers have been shaped by seemingly rare runs of good form. Performance consistency is also often used as a tool for rating and filtering active fund managers – with skill linked to how regularly they beat their benchmarks over each year/quarter/month. To think that the delivery of regular benchmark beating returns is indicative of skill, investors need to believe one of two things:
- For a fund manager or team to outperform consistently, investors must suppose that they can accurately predict future market conditions. Without having this ability, it is impossible to position a portfolio to outperform in a constantly evolving environment.
- Financial markets will consistently reward a certain investment style. If investors do not accept the first notion, then they must believe that a fund manager has a flawless approach that always outperforms- regardless of the market conditions.
Stories over randomness
The existence of consistent outperformers is almost certainly the result of fortune rather than skill. In any activity where there is a significant amount of randomness and luck in the results, outcomes alone tell one next to nothing about the presence of skill. The only way of attempting to pinpoint skill is by drawing a link between process and outcomes. In order to claim performance consistency is evidence of skill, one should justify the part of the process that leads to such unwavering returns.
Consistently poor behavior
The obsession with performance consistency is not just a harmless distraction, but an issue that leads to poor outcomes for investors. There are three main problems:
- It leaves investors holding unrealistic expectations about what active funds can achieve. A rule of thumb to follow- if a fund has outperformed the market for five years straight, then at some point it will underperform for five years straight.
- Buying funds that have shown unusually strong run of performance leads to entering markets at expensive valuations. Markets tend to converge to their mean values over time and by walking into expensive valuations investors may have to sit through painful mean reversion.
- Narratives surrounding consistent outperformance promote the glorification of star fund managers.
Source: The Myth of Consistent Outperformance by Joe Wiggins on www.behaviouralinvestment.com
Asset Multiplier Comments
- Fund investors should focus on the consistency of the philosophy and process of a fund manager. In an unpredictable environment, one’s investment approach is the only thing that can be controlled.
- Believing that consistent outperformance is the evidence of skill can lead to capital erosion.
- Instead of chasing active mutual funds, investors can go passive. Sticking to this approach in a disciplined way will ensure slightly better performance than active funds over the long run as fees are comparatively lower.
Disclaimer: “The views expressed are for information purposes only. The information provided herein should not be considered as investment advice or research recommendation. The users should rely on their own research and analysis and should consult their own investment advisors to determine the merit, risks, and suitability of the information provided.”