Financial Opinion and Insights

Driving Forward While Looking In The Rear-View Mirror?

Jim Lorenzen, CFP®

Believe it or not, many investors do just that – including many professionals.

A study by Advisor Perspectives’ Robert Huebscher conducted between 2004 and 2009 has confirmed what some advisors have known for a decade – and reveals what many still haven’t figured out:  Not only are past performance ratings poor indicators of future success, they may actually be worthless.

“Our analysis found that Morningstar’s ratings lost virtuall all of their predictive ability when measured over a full market cycle… Advisors might just as well flip a coin to decide whether to move to a fund with a rating that is one star higher.”

Huebscher isn’t alone.  Other studies have confirmed that those stars are of little help.  The reason is fairly simple:  The stars are based on a 20/30/50% weighted average of three, five, and ten-year periods.  The time period used in Huebscher’s study actually includes a half-million fund-month observations of all US equity funds. 

In spite of this and other studies going back more than a decade – I first became aware of this issue, if memory serves, back in 1994 – many advisors still use these stars and other performance ‘indicators’ when making investment decisions.   While some may be trying to simply justify a sale, my guess is that many see third-party indicators as objective justification; a ‘CYA’ move to gain a perceived protection and make their compliance departments happy.  Unfortunately, it appears no one’s really obtaining any real benefit.

Many investors tend to believe that the longer the track-record of the fund, the more likely superior management skill will be revealed.   Huebscher’s study also appears to reveal evidence that just the opposite is true:  Predictive power declines precipitously when going from one to three to five to ten year performance numbers.  My guess:   Most funds have management turnover and while some add value, most don’t.   Huebscher’s report apparently does not compare the predictive value of the indicators for only those funds where managers have been on the job for the full amount of each time period; nevertheless, I wouldn’t expect a great difference in the outcome.

What do the studies suggest? 

Rather than looking backward, it appears better to look at current behavior; particularly those managers that follow a disciplined and consistent strategy and those that have a ‘high-conviction’ stock selection strategy.

                     “Diversification is protection against ignorance.”
                                                                                     – Warrren Buffett

Many highly successful investors believe that concentrated portfolios are an investor’s best hope for achieving excess returns in the market.  The reason for this is simple, when you think about it. 

First, as students soon learn when they take Financial Planning 101, it’s impossible to diversify away market risk!    I know, that sounds contrary to everything you’ve heard, but it’s true.   If the S&P 500 index represents the broad market for large-cap stocks and you have only 10 stocks, you’re likely in a portfolio that will be more volatile than the index.   But, no matter how many stocks you add, you can’t diversify away the index’s market risk.  In fact, if you bought all 500 stocks, you would only replicate the market risk, not diversify it away.

 But, as indicated, a concentrated portfolio like the 10-stock one mentioned above is likely much more volatile than the index, which is why this isn’t something non-professionals should attempt.  However, for some of them, a portfolio concentrated in their best stocks – a high-conviction portfolio – appears to do better than the ‘stars’ would indicate; so, clearly, past performance isn’t where one should look.

It’s What They DO, not what they did.

Bottom line:  Current behavior is more predictive than past performance.  And, portfolio analysis is just what it sounds like:  More analytical – green eye shades help – than observant.

Written by Jim Lorenzen, CFP®, AIF®

June 29, 2010 at 9:59 am