Content provided by Jackson Lee, Quantitative Investment Research Analyst
Thanksgiving has always been one of my favorite holidays. Besides stuffing myself with seemingly bottomless turkey and desserts, I enjoy the tradition of reflecting on what we are grateful for and taking time to be with our loved ones. But if your family is like mine, the holidays can also be a time when we have to sit through some family members bragging about their accomplishments and generously handing out investment tips. I am sure this one is going to come up this year: “You should buy FANG stocks! They have all beaten the S&P 500 by double digits, and they will definitely continue to soar!”
While I am sure their advice is given in good faith, more often than not, it is exactly the opposite of what a successful portfolio needs. It is natural for human beings to chase performance — selling the recent losers and buying the winners or, in other words, buying what has become expensive and selling what is now considered cheap. This type of behavior is not confined to retail investors; institutional investors often fire managers who have underperformed and hire winners based on their performance over the past three-or-so years. So, does this strategy work?
According to this study from Research Affiliates, the answer is no. In fact, the recent winners on average underperformed the recent losers by about 1% based on the three-year subsequent performance. The main reason for this phenomenon is most funds tend to have persistent factor exposures. Very few managers are disciplined enough to pull back on what has been working well for them, which is now expensive. Here are some of the key highlights:
- Past winners are often future losers, and vice versa.
- Persistent manager skill is rare.
- Other than recurring costs, most performance is mean reverting.
If past performance is not a good predictor of the future, how should investors choose fund managers? At CLS, we believe a good active manager should have the following qualities (these can also be found in the CLS Reference Guide):
What’s most important is choosing a manager who fits your investment style and will help guide you through the cycle of investor emotions. While your friends and family are great sources of support and advice for other things in life, money management is better left with the professionals, particularly experienced professionals like those at CLS.