The Downside of Past Performance

“90% of what passes for brilliance or incompetence in investing is the ebb and flow of investment style.” – Jeremy Grantham

The typical fund pitch book has some combination of the following:

  • Our team has X year of combined experience.
  • Our track record set against the S&P 500 is as follows…

I understand the need to point out market experience and past performance. The market provides a running scorecard of investment successes and failures.

I just think far too many people in the finance industry overestimate the role of skill and underestimate the role of luck on their results. There can actually be a downside to using past performance as one of your main metrics when choosing a money manager:

  • A great track record can attract the wrong types of investors who are only into chasing fads.
  • Past performance without context can be useless because the investment style, market environment and assets under management when that performance was earned are all very important factors, especially if it was created over a relatively short period of time.
  • Past performance is no substitute for how a specific process will play out in the future.
  • Overconfidence following a run of outperformance can cloud the decision-making ability of even the best investors and incentives can change after money managers have established a decent track record.
  • Performance is often confused with process, which is the only thing that matters going forward.

Howard Lindzon had a great post this past week discussing the fact that past performance is overrated:

It’s 2016 and still almost every piece of financial research and literature (mostly crappy) comes with the warning…’past performance is no guarantee of future success’.

It’s ass backwards.

I have made most of my money betting on myself and other people with little to no track record.

In my world…’future performance would have been limited if I had not backed people with limited performance history’.

That’s another problem with a focus on past performance when vetting an investment opportunity — you potentially limit yourself to those who have an established track record.

One of my favorite stories on this involves David Swensen, arguably one of the greatest investors of all-time. Swensen’s track record running Yale’s endowment fund is unmatched in the institutional investment industry and spans more than three decades. He didn’t exactly have the greatest track record when hired for this now prestigious position. In fact, he had no track record at all and no experience whatsoever in portfolio management. Here’s the story, as told by Peter Bernstein:

Lehman Brothers lured Swensen away from Salomon Brothers, but the stint at Lehman would turn out to be brief. One day Tobin and Brainard called from New Haven to talk Swensen into taking over the management of the Yale endowment fund, a position that had been open for some time. Swensen balked, complaining, “I don’t know anything about portfolio management.” His former professors refused to take no for an answer. “That doesn’t mater,” they told him. “We always thought you were a smart guy, and Yale needs you.” As a loyal Yale alumnus, they insisted, Swensen was obliged to take on the job. There are lots of jokes about economists and their hilarious failures at forecasting, but Swensen’s track record goes a long way to demonstrate that Tobin and Brainard knew what they were doing when they flattered him into taking a position he never thought he would hold, much less aspire to.

Swallowing an 80 percent cut in pay, Swensen said yes to Tobin and Brainard, and moved himself back to New Haven. His salary is now a respectable one by most standards, but far below what the major players at thousands of hedge funds and other investment organizations take home for their efforts. For Swensen, this job has been a labor of love.

The fact that Swensen took such a huge pay cut to leave Wall Street to take a job for his alma mater says a lot about his character. Sure, they were taking a chance on him, but he was taking a big career risk as well. Obviously, Swensen is an outlier of sorts in that he eventually went on to basically master the art of institutional investing. But had his former professors based their entire search process on past performance alone they never would have considered their former protege.

Past performance is overrated while process and a person or organization’s character are extremely underrated.  I’m always suspicious when performance is the entire reason for choosing a strategy, fund, portfolio manager or advisor. People and process are much more important when trying to figure out how performance will play out in the future.

Past Performance is Overrated… (Howard Lindzon)
Capital Ideas Evolving

Further Reading:
Experience or Expertise?