Why The Smart Money Chases Performance

The fund I used to work for was invested in an investment manager that performed very well in 2008 when the majority of asset classes and portfolio managers were getting destroyed by the financial crisis and stock market collapse.

This particular strategy was up double digits in a year when stocks fell close to 40%. This fund had billions in AUM but it had been closed to new investors for a number of years (a good sign in my book). Following their good fortune they decided to open things up to new investors because they said they thought they finally had enough capacity to accept more outside money (a bad sign in my book).

And wouldn’t you know it, following a string of outperformance and tons of fresh new capital, they went on to badly underperform in the ensuing 5 year period. Persistent outperformance is nearly impossible, but it’s made harder still when funds get too large to outperform as size is the enemy of alpha.

In some ways you can’t even blame this fund for cashing in on their financial crisis success. They struck while the iron was hot. Institutional investors are more than happy to chase performance — to their detriment — again and again. Take a look at this chart from a recent Vanguard blog post on the perils of institutional investors chasing performance:

Screen Shot 2016-01-04 at 10.57.28 AM

This chart shows how institutional investment committees continually make their investment manager decisions based on past performance, only to be disappointed by the subsequent returns once they invest. They hired managers that outperformed and fired managers that underperformed only to see those roles reverse after their investment moves were made.

The “smart” money has a nasty habit of buying winning funds after they’ve just won and selling losing funds after they’ve just lost. It’s something of an anti-value, anti-momentum approach where these large funds are always one step behind and fighting the last war.

There are plenty of great portfolio managers out there. But there probably aren’t enough asset allocators or organizations who can discern when to invest with a great portfolio manager and when it’s time to move on. This process is made even more difficult when a large committee has to come together to make group decisions.

It’s not simply that markets are hard. There are many external factors that cause the performance chase to continue. When you manage large sums of money — like a pension, endowment, foundation or family office — there’s never a shortage of funds looking to pitch you. New investment opportunities are seemingly endless. The temptation is always there to make changes to your portfolio. There’s always a new shiny object to draw your attention.

Investment officers and consultants also have to justify the fees they’re being paid. Doing nothing, even when it’s the right thing to do, isn’t easy when others expect to see short-term results. Often times the best thing you can do as a fiduciary is stand between your decision-makers and a huge mistake at the wrong time. Easier said than done during a period of poor relative or absolute performance. Career risk can be deadly to a solid investment plan. Hiring and firing managers is also a nice way to find someone else to blame for poor performance.

A lack of constraints that most individuals deal with also plays a role here. There are little or no taxes paid on the majority of institutional portfolios. The time horizons for many of these funds is technically forever. Plenty of endowments have rich benefactors that continue to make large contributions every year. Take away the constraints of taxes, a defined time horizon and the need for new sources of capital and some of these funds go overboard.

The result can be a huge mismatch between the long time horizon these funds share and the short time horizon used to make investments.

Learn more about our institutional practice here.

The Returns Rollercoaster (Vanguard)

Further Reading:
Consulting & The Smart Money Herd Mentality


This content, which contains security-related opinions and/or information, is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances, and should not be relied upon in any manner. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment.

The commentary in this “post” (including any related blog, podcasts, videos, and social media) reflects the personal opinions, viewpoints, and analyses of the Ritholtz Wealth Management employees providing such comments, and should not be regarded the views of Ritholtz Wealth Management LLC. or its respective affiliates or as a description of advisory services provided by Ritholtz Wealth Management or performance returns of any Ritholtz Wealth Management Investments client.

References to any securities or digital assets, or performance data, are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.

The Compound Media, Inc., an affiliate of Ritholtz Wealth Management, receives payment from various entities for advertisements in affiliated podcasts, blogs and emails. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. Investments in securities involve the risk of loss. For additional advertisement disclaimers see here: https://www.ritholtzwealth.com/advertising-disclaimers

Please see disclosures here.

What's been said:

Discussions found on the web
  1. MG commented on Jan 11

    I agree with what you wrote, but another reason for why the smart money chases performance that you did not mention is that institutions often employ ‘Window Dressing’ which is where portfolio managers near the quarter or year end invest with a recent outperformer to improve the appearance of their portfolio, before presenting it to clients or shareholders. By buying the great performer after the fact they can imply that they are investing with the best, even if they missed the entire period of outperformance.

    • Ben commented on Jan 11

      It’s insane that this practice still exists, right? Hard to believe investors fall for it but it shows you how little due diligence is performed by many organizations and funds.

  2. cannew commented on Feb 01

    Not sure why they call it Smart Money? My personal opinion is to invest for Income, not past performance (or even trying to match market performance). Usually if your stocks continue to increase the income, growth will follow.