While the concept of setting aside savings to generate a return (aka investing) sounds straightforward, a combination of instincts and biases (collectively termed “behavioural finance”) make this harder than it should be. As humans, we face social pressure, and struggle to deal with information and time.
When it comes to timing, investors can be their own worst enemies. We have previously conducted research on our own clients’ outcomes which suggested that entering and exiting at the “wrong” times can cost on average a few per cent each year, and this effect is backed up by industry studies.
The herd has a tendency, in aggregate, to chase assets that have performed well. In running a fund management business, we note that inflows tend to follow good performance and vice versa.
Ironically, it is this very tendency we try to exploit when looking at stocks by appreciating that good companies going through a soft patch can be overlooked and hence offer outsized rewards to investors.
While a successful approach to investing is to buy cheap stocks and to sell expensive ones, there is nothing to stop expensive stocks rising or cheap stocks falling further. In the short- to medium-term, sound processes can, and often do, deliver poor outcomes while poor processes can, and often do, produce good outcomes.
Many years’ experience tell us that investment returns are the key driver of fund management business success, if that is to be measured by net inflows, i.e. the balance of subscriptions less redemptions. The problem faced here is that, for managers, the cyclical pattern of performance leads to a cycle in the demand for the manager’s services that is counter to the best outcome for clients. This is a sad observation on the investment industry’s relationship with its clientele.
In practice, if a firm starts with good performance, it could be luck rather than skill. But we know the lucky get luckier, they attract more capital to manage, they grow their businesses and they become more visible. Their opinions seem most valid, and fill the business TV channels, often just as their luck runs out, and “mean reversion” starts to kick in.
In looking at our business, we found that a simple algorithm has historically been a very good predictor for future flows. We have also looked at this for peers in our sector. We simply average each of the one- and three-year relative and absolute returns.
The results highlight three trends:
(1) Allocation to an asset class is driven by its recent returns.
(2) Within asset classes, top performing managers over recent history attract business.
(3) Time frames are shorter than one would hope, but consistent with short holding periods for individual stocks and a “league table” mentality.
Sadly many advisers still start a meeting with representatives of fund managers by asking “How are your [business in-] flows?”. This question, which simply asks what the collective of other investors is doing, plays to our deep desire for acceptance, for social proof.
However, as we have highlighted, flows are a function of recent performance and so the question is really asking “what was your recent performance?”. For all performance is the holy grail of investment management, recent outcomes simply reflect how a portfolio performed under the one of an infinite number possible scenarios that did in fact unfold. Professional risk analysts compound the problem for end investors by using this one realised and measurable path to determine how portfolios might perform under all possible and immeasurable future ones.
None of this tells us the only things we need to know when investing with an active fund manager. What is the manager’s edge, and is that edge sustainable?
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