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What happens in the markets and in the investment process matters

 The investment process should be the first and most important criterion when choosing a wealth manager and selecting an investment strategy. Performance is not only an objective, but also always the consequence of a well-designed investment process. No process is infallible in the sense that it will always work and in all market conditions, and all too often, a client does not ask enough questions or only looks at a historical performance track record. The actual performance of a strategy, which is usually good when shown to potential investors, may depend on one or two decisions made by the wealth manager. However, this should not be as convincing as a solid investment approach that relies on multiple sources of return. 

Clearly, to make a useful and informed judgement about performance (whether positive or negative), one must know exactly what happened in the relevant markets during the period under review and be familiar with the manager’s investment process in order to assess whether the outcome is consistent with the investment approach applied. 

To make a long story short, evaluating performance is not about looking superficially at a number but rather requires a somewhat more nuanced approach and analysis. Otherwise, one runs the risk of drawing false conclusions, false positives and false negatives.

Sometimes a strategy goes through a period of negative performance for exactly the right reasons

Performance is always a combination of passive (market-dependent) and active (non-market-dependent) returns. Market exposure, as well as the active or passive management of asset classes composing a portfolio, must be taken into account. The legendary hedge fund Bridgewater Associates produces a very useful calibration of the expected returns of their flagship strategies by simulating the possible scenarios of future portfolio performance and graphing the resulting return paths, producing an overall cone-shaped range of future portfolio performance. The message is very important for investors because it is a reminder that every active strategy goes through periods of under- and overperformance, which is not only right but even healthy.

In equities, skilled managers with high-conviction positioning will actually spend more time slightly losing returns on a relative basis but then ultimately reaping excess returns when their portfolio calls come true. For this reason, investors should look for strategies that exhibit what is called positive skewness. This means that managers should make more money on winning trades than they lose on losing trades. This should be preferred as compared to strategies that exhibit negative skewness, i.e. many small gains and sudden large losses (e.g. a short put strategy). 

Horse race set-ups are suboptimal

The surest way to harvest negative alpha is a ‘horse race set-up’. Here is how it works. The first step is to create a strategic allocation in a single- or multi-asset context, usually with the support of an external advisor. In the second step, the client and his/her advisor perform a beauty contest and select three to five managers to whom they give the same mandate, i.e. to beat the strategic asset allocation within some predefined risk budget parameters, such as tactical allocation limits, tracking error, etc.

This form of investment management approach has one very significant drawback. The selected managers (who hopefully are all rational profit maximisers) have a clear incentive to hug the benchmark, as extreme positioning risks short-term underperformance and getting fired before their conviction calls play out. In essence, investors are paying active fees to managers who actually replicate the benchmark with their portfolio. Sometimes there are very good reasons to switch managers, but recent performance may or may not be one of those good reasons. If investors blindly fire the weakest managers, they run the risk of reaping negative relative (or negative absolute) returns over and over again.

Absolute versus relative performance 

‘Absolute versus relative’ is one of the most controversial and emotional topics on the performance subject. The proposition for absolute return strategies is always the same: ‘Our investment process seeks absolute returns and protects our clients’ capital during market downturns’. However, there are several reasons why this claim does not hold water.

First, the real benchmark for wealthy investors is the performance of the equity and property markets. Above a level of wealth greater than that needed to cover current expenses, investors become poorer in relative terms if their wealth does not keep up with the development of these two main real asset classes. 

In a capitalist system, markets spend more time rising than falling, and the explanation that one loses less than the markets in downcycles to justify underperformance is highly ‘questionable’ over the entire duration of the cycle. Our philosophy is that the first and cheapest way to protect your assets from future downturns is to take full advantage of the uptrend in good times, creating a cushion for the inevitable downturns when they come. As mentioned before, investing is not about taking advantage of the good times in bull markets and leaving the bad times to others. 

Second, it is possible to generate positive returns that are independent of the direction of the markets; however, very few money managers have managed to do so in a consistent, repeatable way and continue to do so accordingly. This is called true ‘alpha’. Funds that succeed in consistently generating alpha are generally closed because their capacity is limited. Alpha only ever exists in small quantities, because, in aggregate, it is a zero-sum game. The bottom line is that we all rely on relative returns. Products with absolute returns look attractive, but only a tiny minority actually create value.

Simulated track records and backtesting 

Many asset managers are constantly looking for profitable active strategies, and their work often involves backtesting, a rules-based performance simulation using historical data. Not surprisingly, in the more than 25 years that I have been a Chief Investment Officer, no one has ever come into my office with a backtest that did not work. Hypothetical historical investments are relatively easy because one knows what happened in the past. Typically, however, based on anecdotal and empirical evidence, once real money is put to work, these strategies no longer work.

Dollar amounts count more than percentages 

Most people look at performance track records in terms of percentages achieved over certain time frames. In most cases, this is an oversimplified assessment and raises a number of problems. First, the starting point for a series of performance figures plays a major role. More importantly, some managers have an interesting performance in percentage terms but have achieved the good periods with little capital under management and, subsequently, the less good periods with much larger amounts of capital under management. A manager with a positive relative performance in percentage terms may have underperformed in pure dollar terms, and the average investor in the strategy over the period might have underperformed. When withdrawing money from or adding money to a strategy, an investor should use the money-weighted rate of return (i.e. the internal rate of return of a series of cash flows that are flowing into or out of an investment strategy) rather than the time-weighted rate of return to get a more helpful representation of how the investor’s money has grown or shrunk over a period of time.