There are few things the active fund management industry likes more than a tale of a manager consistently outperforming the market, year after year. It seems that there is no better sign of investment acumen than to overcome the odds and produce excess returns with unerring regularity. The problem is that this notion is entirely spurious. Patterns of consistent outperformance are exactly what we would expect to see if results were entirely random. It is a measure that alone tells us nothing, but a belief in its significance is likely to lead us toward an array of investing mistakes.
Throughout my career there has been a fascination with hot streaks of outperformance from active fund managers. The careers of most star fund managers have been forged on seemingly rare runs of good form. Performance consistency is also often used as a tool for rating and filtering active fund managers – with skill linked to how regularly they beat their benchmarks over each year, or even each quarter or month.
Although it instinctively feels that consistent outperformance should be a marker of skill, it pays to think through the underlying assumptions that must hold for this to be true.
To think that the delivery of regular benchmark beating returns is indicative of skill we need to believe one of two things:
1) A fund manager or team can consistently predict future market conditions.
For a fund manager to outperform on a consistent basis and for us to consider it evidence of skill, then we must suppose that some individuals or teams can accurately predict the forthcoming market environment. If they cannot, then how they possibly position their portfolio to outperform through a constantly evolving backdrop?
2) Financial markets will consistently reward a certain investment style.
If we do not accept that a fund manager can predict the prevailing market backdrop each quarter or year (which we shouldn’t, because they can’t) then we must believe that a fund manager has an unimpeachable approach that always outperforms – no matter what the market conditions. It is a strategy that is impervious to cycles and styles.
It is difficult to discern which of these claims is more incredible, but if we are using performance consistency to inform our investment decisions then we are implicitly making (at least) one of them.
Stories over randomness
The overarching problem is one of narrative fallacy. We refuse to accept a randomly distributed set of performance numbers, instead we must build a compelling story to explain and justify them.
If we had a universe of 500 fund managers and each selected their portfolios based on the names of companies that they picked out of a hat we would still witness spells of consistent outperformance. We could easily create a captivating backstory about why a certain fund manager was able to beat the market with such regularity even if the results were based entirely on chance.
If there was no persistent skill or edge in active fund management (which is not an heroic assumption to make) and all results were entirely random, performance consistency would still make it appear as if skill existed.
The existence of consistent outperformers is almost certainly the result of fortune rather than skill.
In any activity where there is a significant amount of randomness and luck in the results, outcomes alone tell us next to nothing about the presence of skill. The only way of even attempting to locate skill is by drawing a link between process and outcomes.
If we are claiming that performance consistency is evidence of skill then we must also show which part of the process leads to the delivery of such unwavering returns.
Consistently poor behaviour
Unfortunately, the obsession with performance consistency is not just a harmless distraction, it is an issue that leads to poor outcomes for investors. There are three main problems:
1) It leaves investors holding entirely unrealistic expectations about what active funds can achieve. Consistent outperformance is unlikely to occur in the fund we own and, if it has occurred in the past, we should not expect it to persist into the future. A better rule of thumb would be if a fund has outperformed the market for five years straight then at some point it will underperform for five years straight.
2) If we buy funds following an unusually strong run of performance, we are increasing the odds of walking into expensive valuations and painful mean reversion. Rather than consistency being an indicator of skill, it is more likely to be a sign of more difficult times ahead.
3) The narratives that are weaved around consistent outperformance foster a culture of undue adulation for star fund managers. Adulation which always ends well…
Fund investors should stop focusing on and thinking about consistent excess returns – it tells us nothing meaningful – and instead concentrate on consistency of philosophy and process. In a complex, unpredictable system that is all that can be controlled.
A belief that consistent outperformance from an active fund manager is an indication of skill that is likely to persist is not only wrong, but also dangerous. Flawed expectations about the realities of active fund management inevitably lead to poor behaviours and disappointing outcomes.