It’s a regulatory requirement that publicized returns for managed investments include the disclaimer: ‘past performance is not necessarily indicative of future results’ which is intended to inform investors there is no guarantee results can be repeated.
Market conditions change frequently and the strongest investments last year could be the weakest next year. Unfortunately, this disclosure doesn’t always have the desired effect.
When it comes to performance chasing for managed investments, it’s normal for people to wish they had put everything they owned with the highest returning manager.
However, while rebalancing your portfolio to sell the underperforming positions to buy the top performers may be a natural response, it’s not wise. It’s important to avoid putting too much emphasis on short term performance when making decisions on your long-term investment strategy. It’s preferable to focus on results with five, seven and 10 year returns. It allows you to see how consistently the manager has performed in different market conditions. While a three-year return is better than one year, even three years should be taken with a grain of salt. It’s not unusual to see commodity investments take the top spot one year, only to come in last the next.
Market dynamics change from year to year and there is downside in any strategy. If your manager underperformed in any given year, it could be because they took less risk or market conditions favoured strategies that focused on a narrow (but higher risk) sector of the market. This is why diversifying your portfolio to include a few different managers can improve your risk management without hurting returns. Two different equity managers may have each made nine per cent annually over seven years but the actual year over year performance of the two could be quite different. A reason to include both is because without a crystal ball, there’s no way to know what the market conditions will be. Studies have shown that trying to switch between managers based on short term performance results in underperformance. If you’ve done your due diligence and chosen managers with consistent, long-term returns, your three-to-five year returns should reflect that.
When we interview other managers and review their investment strategies, the number one question we have is: “How will they perform in a bad year?”
Scrutinizing bad market years like 2008, 2011 and 2015 can be enlightening. It’s also important to look at other risk metrics like maximum drawdown (the biggest per cent decline the fund has experienced from a peak), time under water (how long did it take to get back to the high water mark) and standard deviation (volatility of the returns). The Sharpe ratio is a good indication of risk adjusted returns because it gives you a ratio of return per the unit of risk taken. Putting it together, you can get a much better understanding of manager skill by going beyond returns and looking at other metrics.
It’s impossible to beat the market every single year. But there are managers who consistently outperformed the market on a longer-term, risk-adjusted basis. The best strategy is to focus less on what the market is doing and instead, develop an investment plan that targets the returns you want within a risk level you are comfortable with. Then you can develop a financial plan to ensure your targeted return will allow you to achieve your financial goals.
The bottom line is that performance chasing has been proven to actually lead to underperformance. Stay focused on the longer term results and you’ll be better positioned to stay on track with your financial plan while sleeping soundly at night.
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Lori Pinkowski is a Senior Portfolio Manager and Senior Vice President, Private Client Group, at Raymond James Ltd., a member of the Canadian Investor Protection Fund. This is for informational purposes only and does not necessarily reflect the opinions of Raymond James. Past performance is not necessarily indicative of future performance. Lori can answer any questions at 604-915-LORI or [email protected]. You can also listen to her every Monday morning on CKNW at 8:40 a.m.
