I find that more often than not when typical investors are making decisions about what to invest in, they anchor their reasoning to recent performance. Whether it be 1, 3, 5, or even 10 or 15-year performance, many investors believe that managers that performed well in the past will continue to do so in the future.
But as we all know, past performance is no indicator of future results, and any investment methodology based on this type of performance chasing will likely lead to nothing but disappointment.
Though the vast majority of managers underperform their benchmarks, there is usually around 20 or 30% or so, perhaps just by random luck, that does, in fact, outperform their index. A lot of people assume that this type of outperformance implies some sort of skill on the part of the manager – why wouldn’t you expect this performance to continue in the future? Surely you can just choose from that 20 % or so of managers who outperformed in the past and expect favorable results right?
All it takes is a simple look at the data to understand why this is a fool’s errand. If you look at the number of funds who beat their benchmark over 3, 5, and even 10 years, only about a quarter of these winners continue to outperform in the subsequent time period.
So clearly the odds are not in your favor for outperformance with any single manager, but when you consider most people use several different funds or managers for different asset classes in their portfolio, the odds of all of those outperforming becomes astronomical.
When these managers fail to live up to investor expectations, they are most likely dumped from the portfolio and replaced with new managers who have outperformed the index in the recent past, and the cycle repeats itself. I have dubbed this process the active manager “not-so-merry” go round.
So what is the impact of this type of performance chasing behavior relative to a simple buy and hold strategy?
Fortunately, Vanguard performed this exact analysis. The two approaches and their pre-set rules are described below.
Across every single asset class, buy and hold investors were better off than their performance chasing counterparts, and by margins that would have a material impact when it comes to achieving a client’s financial goals. Of course, past performance is no indicator of future results, but I find the research compelling.
So clearly, when it comes to investing, it pays to dig deeper into the research underlying concepts like manager performance and use the research to shape your investment philosophies accordingly. Armed with this research (and a bit of common sense), we can be confident that we are serving our clients best interests with a simple buy and hold approach to investments.
And that, my friends, is why we do not chase manager performance.