Dan Williams, CFA, CFP, Investment Analyst
A common movie plot device is giving the story’s protagonist the ability to redo the past and see what might have been. For example in “The Back To The Future” franchise we have Marty McFly shown the huge changes to the present or future based on a few changes in the past. Marty then gets to pick the better fork(s) in the road. Others, for example “Groundhog Day” and “Edge of Tomorrow”, give the protagonist the unlimited ability to replay a single day until he gets it perfect. Regardless of the specific parameters of the do-over mechanism, this is not the way life goes. We can learn from the past but we can never go back to relive it verbatim.
Time travel is of course science fiction but the desire to try to rely heavily on what worked yesterday to plan today is very real. The problem is that the more we perfectly optimize for the past conditions and “fight the last war”, the more likely the rigidness of the perfect solution reached is not applicable to the future. During the 1930s, France built the perfect World War I military defense with the Maginot Line but found themselves outflanked very quickly by the new warfare of World War II. Similarly, at Brinker Capital, we come across strategies that are back-tested to show amazing results but a later review shows subsequent performance to be average at best.
For very good reason the disclaimer goes, “Past performance is not an indicator of future results”. Yet investors continue to chase returns and buy the investments today that they wish they had held yesterday. As asset allocators, our goal is to identify strategies with compelling advantages relevant to future performance rather than those that already have had their moment in the sun. This to say the goal is to identify the strategies that have a good chance to work well in the future and we should consider past performance only if it is helpful in projecting future performance. Sometimes past performance provides a proof of concept in the strategy’s investment process/philosophy. Other times the past performance are period specific and should hold little weight in the present allocation decision. Knowing the difference is easier said than done.
In this pursuit of separating the gold from the fool’s gold in investment strategies we find valuable insight in both quantitative and qualitative characteristics. The Brinker Capital Investment Team often does look at the historic performance and holding statistics of an investment manager. But we also evaluate the organization and the people in the organization. Does the organization put the investor first? Are the members of the investment team talented, experienced and trustworthy? Are there new relevant competitors in this area of the market? These things matter. This is all in addition to an evaluation of market conditions to suggest success in the asset class as a whole.
The recent arrival of a multitude of Smart Beta/Factor products to the marketplace is especially relevant to this discussion. These products are all well-supported with academic research and have attractive back-tested long-term returns. In theory, these grand returns could have been achieved had both the investment firms had the foresight to make these strategies available and investors had the foresight to invest in them. There is, however, reason for skepticism with using this past performance carte blanche for future investing.
- First, this strong performance was achieved when investors were not widely aware of the ability of these factors to outperform. Going forward the widespread knowledge of these factors’ alpha potential could cause investors to flock to securities with these attributes causing these securities to become overpriced and leading to a significant muting of future performance.
- Second, the conditions that these factors outperformed are market conditions of the past. This is to say, these factors may have worked over the past 25 years but may not work for the next 25 years. At the very least we have to consider the possibility that the desire to invest in these strong past performers is more driven by trying to redo the past rather than sound forward-looking investing.
This is not to say that all Smart Beta/Factor and strategies that use back-tests are doomed for failure but rather it is never as simple as doing today what worked yesterday. It would be equally thoughtless to eliminate any strong past performers as it would be to blindly chase them. Some of these factors I expect will show robustness and continue to do well into the future. Others may prove to have just been the result of statistical anomalies, past specific market conditions and data mining.
At Brinker Capital, we believe that strong active management can be found but that it takes a strong due diligence process to find them. It also takes patience and a forward-looking focus.
The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Brinker Capital, Inc., a Registered Investment Advisor.