Thoughts on past performance as an indicator of future performance

Knowing personally that I’ve persistently outperformed benchmarks over periods of 3 year plus since 1976 is leading me to the conclusion that it can’t all be down to random luck. Perhaps as Gary Player once responded to a greenside comment about a lucky putt- “The more I practice, the luckier I get”.

There is no doubting the academic evidence (see below) that industry wide past performance is not a reliable indicator of future performance. Few fund managers display persistent performance.

The position in Australia is slightly better than the position in the USA and UK. More investment managers have shown persistence. I attribute that to the greater prevalence of “boutique” investment managers in Australia, run by a single experienced investment manager or a very small team, who own a fair chunk of the investment business and invest their own money in the fund, and are just large enough to make it into the studies;

Large investment managers make up the bulk of the participants in these studies because they are researched by research houses. Smaller boutiques are mostly “under the radar”.

I’m obliged to a Morningstar executive who pointed out that because of the increasing numbers and scale of large passive investment managers, as ETFs have grown in popularity, it’s actually getting theoretically easier for active boutique investment managers to outperform with persistence.

It’s fashionable in the investment industry for an investment manager to follow a particular investment style without regard to whether that is the best opportunity going forward. For example, the 1972 bull market peak heralded in the decline of the “nifty fifty” growth stocks and a very long period of about 15 years where a “value” approach outperformed a “growth” approach. So while I was in stockbroking in the eighties it was value managers like Maple Brown Abbott who dominated the headlines and the performance statistics.

We’ve now had an unprecedented decade where growth stocks have outperformed value stocks, particularly at the smaller company end, because the money has poured into large cap, especially US growth stocks like Amazon, Microsoft, Nvidia, Meta, Apple.

Fortunately for me, a “disruptive” thematic has been highly successful during this period, as new businesses supplant the new order.

But I have no illusions that at some point, often as interest rates are rising, there will be a swing back towards deep value stocks and they will have their day (some years) again in the sun.

If you stick with the same approach unwaveringly, well it’s almost locking in lack of persistence ability.

Likewise all our models are benchmark unaware. We do try to beat them, but we certainly don’t try and look like them while doing so. If you are essentially replicating an index, then it’s much harder to outperform it.

So why don’t conventional fund managers try the beat the index handsomely? To “persist”. It’s what Keynes termed the institutional imperative. It’s safer from a business perspective to do badly along with all your competitors than risking doing much worse by trying to do much better by going out on a limb and failing.

Having “persistently” outperformed various benchmarks over three year plus time periods for the past 48 years what are my chances of doing so in the future?

Well one observation from the research below is that long-term persistence tends to be associated with future long-term persistence. I’m much more likely to continue to be persistent over a six year plus time frame than over a one to two year time frame.

So the longer you invest with Aldersley Capital Direct, the more certain I become that you will experience the benefit of persistent outperformance. If your time horizon is merely one or two years, the adage definitely prevails: “past performance is not a reliable indicator.”

“Past performance is not a reliable indicator of future performance”. It is generally treated as a warning label: Don’t assume an investment will continue to do well in the future simply because it’s done well in the past.

But the phrase contains a second less obvious meaning, too: A potential investment opportunities label: Don’t discount an investment strategy simply because it’s done poorly recently – it could improve.

What might the phrase be trying to warn us against or lead us toward in today’s market environment?

It could be warning against staying overloaded on U.S. growth AI stocks. For more on that see below.

Persistent outperformance by investment professionals is rare because:

• There’s the intellectual challenge of identifying winners early–that arguably requires knowledge, insight, creativity, vision, experience;
• But the bigger challenge is behavioural: Having the courage–and inspiring clients to trust your judgement–to occasionally act in a contrarian way and invest in something others don’t see value in yet (that’s probably why the price is low, after all) and then to be patient because you are invariably slightly early.

Drumming up excitement among clients about an investment that is doing well and whose near-term performance is impressive requires less effort overall.

Getting clients enthused about an investment that has hurt portfolios recently but that you believe is likely to turn around despite current uncertainty, requires much more time, conviction and trust amongst your clientbase.

It’s all the more challenging in today’s media circus that eats “patience is a virtue” for breakfast.

Some investors may say they’re invested for the long term, yet they are able to look at their account values every day online. Getting direct investors to “stay the course” is the challenge facing today’s investment managers, especially in the direct investor space.

Just look at these slightly historic numbers below from the NYSE which show how the average holding period has shifted over the last five decades on the NYSE. It’s got much faster in the past decade:

Source: https://www.politifact.com/factchecks/2016/jul/06/mark-warner/mark-warner-says-average-holding-time-stocks-has-f/

Unfortunately, more media information rarely leads to better decisions or outcomes for investors. Rather, it tends to breed impatience as greed or fear (including FOMO – fear of missing out) take over from logic.

Here in Australia, as elsewhere, regulators wish to ensure that in promoting past performance it is not misleading or likely to mislead.

Commendably, in 2002, ahead of their Regulatory Guide 53 on the subject, the Australian Securities and Investments Commission (ASIC) commissioned the Funds Management Research Centre (FMRC) to provide a report on research findings in relation to the performance of managed investment funds. This report was to assist an ASIC project on how past performance information is used in investment marketing.

The central issue asked was “how useful is past performance information when consumers (or their advisers) are selecting an Australian managed fund?”

The FMRC undertook an extensive review of the academic literature on the “persistence” of managed fund performance. If a fund’s performance is consistently above (or below) the average performance for a group of similar funds, this is called “persistence”.

The majority of studies look at US funds whilst a number examined UK funds. A few studies exist of the performance of Australian funds. The majority of studies have examined equity funds.

Although studies address a common topic, they are characterised more by their differences than similarities: the studies cover different time periods, use different benchmarks and reach different conclusions. The Australian studies are broadly consistent with the pattern of overseas research.

• Returns are only meaningful if adjusted for risk/volatility or comparing “like with like”.
• The risk-adjusted studies involve complicated computer analyses that are only available to research houses and academics. They do not reflect the information available to retail investors via advertisements, league tables or formal offer documents.
• Good past performance seems to be, at best, a weak and unreliable predictor of future good performance over the medium to long term.
• About half the studies found no correlation at all between good past and good future performance.
• Where persistence was found, this was more frequently in the shorter-term, (one to two years) than in the longer term. The longer-term comparison may be more relevant to the typical periods over which consumers hold managed funds.
• Bad past performance increased the probability of future bad performance.
• Where persistence was found the general pattern appears to be symmetrical. Short-term past performance is only correlated with short term future performance. Longer term future performance is only correlated (if at all) with longer term past performance.

They offered plausible explanations for these conclusions.

• The methods which work best in one set of market conditions will not work best at other times. For example, value and growth style managers tend to excel at different times. However, it is hard for a consumer to predict the likely market conditions over the next few years. One of the problems with many of these studies is that they might not track a manager through a full cycle of market conditions.
• Fund managers constantly strive to match the performance of competitors. If one firm is outperforming its peers, others will try to copy its methods and/or headhunt its staff. If it attracts a large inflow of funds it is likely to be difficult to place these funds and maintain relative performance, if it is an active as opposed to a passive fund.
• The future return on investments is extremely hard to predict, so a significant part of a fund’s performance (compared to its peers) may be random luck.
• The findings are consistent with other research that shows that it is hard for fund managers to consistently outperform the relevant benchmark.

John Aldersley

5 February 2024