Off to the races

The habit of linking allocations to investment managers according to who did best in a given period of time has a natural appeal. After all, the practice in its generic form (to reward the winners) is applied to many other races we know of: horses, dogs, humans, cars, and even pigs(*).

As usual, the same practice in the investment world can be damaging and lead to errors with dreary consequences. This, again as usual, is due to the complexity of what we are trying to measure – or to how well we have defined the “race” and what does it mean to be the “first”.

What appears as straightforward as clocking Usain Bolt from the beginning to the end of a sprint race is a complex assessment of whether an investment manager (individual or institution) has done what it was hired to do. Being the best performing manager in some periods of time may have been a failure of sorts, either because the manager was not running in the race he signed up for or because the manager arrived first by tweaking the rules. (I’m not even bothering to address the silly annual-best-funds reviews which blatantly mix managers and asset classes into a minestrone of rather poisonous nature.)

First and foremost, do not discount the impact of randomness on any manager’s returns. In fact, this very observation implies there is no point in figuring the winning manager unless your measurement period spans a full investment cycle (from top-to-top or bottom-to-bottom; roughly 5-7 years on average).

Second, define the rules of the race very clearly at inception and make sure you monitor the behavior of participants carefully over time. Even managers with apparently identical mandates may implement their views with implicit biases which in effect make them unfit to be in that particular pool of investors. A classic case was that of institutional fixed income managers in the 1980’s and 1990’s who invested across a broad range of credit exposures while using a government bond benchmark. That worked until credit began to implode more often than desired, at which point everyone woke up to the trick.

Third, and perhaps most important, make sure the top performing manager got there the right way: that is, by following its own investment process, sticking to its fundamental practices and building and retaining its staff and culture. Why? Because if that is not the case, the chances of repeating the feat in future years and cycles will decline precipitously: it will be reversion to the mean of a coin flipper.

Measuring how managers do is not just an exercise of calculating who came out ahead. It’s a lot more work which, unfortunately, needs to be done to make sure you retain the right individual or organization and ditch the ones that deserve to be ditched.

-Notes-
(*) My good friend Michael Tanney, Wanderlust Wealth Management in New York City, sent me the following video from the Wisconsin state fair last summer.