The mid-to-late 1990s in Major League Baseball saw a huge uptick in home runs as steroid use became rampant. Records were being shattered every year as everyone ignored how huge these guys were all getting during a time when there was basically no drug testing.
The steroids era in baseball coincided with something of a steroids era in investing during that same time frame. The S&P 500 was up by 20% or more for 5 straight years from 1995-1999. The NASDAQ Composite was up similarly from 1995-1997 and then shot up almost 40% in 1998 then another 85% in 1999. Venture capital benefitted mightily from the dot-com boom, as well.
Patrick O’Shaughnessy recently sat down to chat venture investor Jerry Neumann to discuss:
I started venture investing in the 90s. So I started in 1997 venture investing and I made a ton of money between ’97 and 2001 even though I had absolutely no idea what I was doing. I had like a 45% IRR for that fund and that actually wasn’t even top quintile. And I was lucky but it also was just an easier time to make money. I mean, anybody could make money. I think that’s not true anymore. It’s not true that anybody can make money. I think you actually have to know what you’re doing.
That period of time was so insane that it would be difficult to judge the performance of the funds or investors. While Neumann continued to be a successful VC, there were many others who got lucky during that period who didn’t fare so well going forward. Trying to decipher skill from luck in those results would have been nearly impossible at that time if you had to make investment decisions based solely on those numbers.
Investors always run up against this skill/luck issue. People who “predicted” the financial crisis in 2008 were seen as soothsayers but the majority of these gurus have struck out ever since. Equity long/short hedge funds have been living off their terrific performance from the 2000-2002 period following the blow up of the dot-com bubble for years. It’s the same for people who predicted the Brexit outcome or Trump winning the presidency.
Everyone has heard the boilerplate disclaimer from the investment profession: past performance is not an indicator of future results. Every investor reads this and tells themselves they’ll focus on process, not past performance. Yet performance is the first thing investors want to look at when evaluating an investment fund or strategy.
Whenever I talk to institutional funds or other investment professionals about our portfolios or our risk management strategy they invariably lead with, “What’s your track record?”
I’m always shocked by how many investors and allocators make their decisions almost purely based on one, three and five-year track records.
It’s insane but I get why there’s so much focus on past performance in the investment industry. It’s the ultimate scorecard. Past performance is tangible while the future is fraught with uncertainty. Everyone can latch onto a good track record because it provides comfort when making investment decisions, even if it’s a false sense of security.
Just like the venture capital example from above, all past performance requires context. There are no easy answers when trying to determine how to use past performance. Each case will be unique. But here are some questions to consider when thinking about how to translate past performance into future decisions:
- How much money was in the strategy during the performance in question?
- Were the best returns earned on a smaller amount of capital?
- What is the capacity for the strategy?
- What was the market environment like?
- How did this strategy do relative to competitors or its benchmark?
- How much risk was involved in earning these returns?
- Do I understand the source or attribution of these returns?
- What are the all-in fees?
- Could this strategy be replicated using a lower-cost method?
- Is the performance live data or a backtest?
- What is the expected range of outcomes?
- Could the outperformance from this strategy be easily arbitraged away?
- Were the returns made based on a sound investment process or manager intuition?
- Why should this process continue to work in the future? Behavioral? Risk premium? Some combination of the two?
What you’re really looking for is a deeper understanding of the cause and effect between the decisions made at the fund or strategy level and the eventual performance. It’s hard to separate ‘was this a good decision?’ from ‘what was the short-term performance impact?’
Reading performance numbers is easy. Calculating risk-adjusted returns is easy. Looking at historical performance graphs is easy.
Understanding the difference between skill and luck is hard. Determining the cause and effect when looking at historical performance is hard. Knowing when to pay attention to past performance and when to ignore it is hard.
The most important question I posed is the last one — will it continue to work in the future? No one can ever know the answer to this one but that’s what makes investing interesting.
Experience or Expertise?