Invest for the future, not the past

Dan WilliamsDan 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.

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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.

Simple is Better

Jeff RauppJeff Raupp, CFA, Senior Investment Manager, Brinker Capital

Simple can be harder than complex: You have to work hard to get your thinking clean to make it simple. But it’s worth it in the end because once you get there, you can move mountains. ~Steve Jobs

If you can’t explain it simply, you don’t understand it well enough. ~Albert Einstein

As an aspiring young basketball player in my pre-teens, I was fortunate enough to have my dad coach my township basketball team. When watching him draw up and teach a play for our team to execute, I decided I, too, could design a play for us. I guess I had always been a bit of an analytic. I went home and proceeded to design what might have been the most complex play ever developed, involving multiple players setting multiple picks, variations depending on how the defense reacted, and multiple passes that required each player’s timing to be nothing less than perfect. I proudly showed it to my dad. He appropriately praised me for the effort and then, to my dismay, declined to implement it Play Callingat the next practice. Naturally, I bothered him incessantly about it, as only kids can do, until he finally sat me down and walked through the play. He pointed out that while on paper the play looked great, if the execution or timing was even slightly off for any of the players, the entire thing broke down. As a team, we were still grappling with the idea of executing a simple pick and roll, so a play this complex was destined for failure. For our basketball team, simple was better.

Years later, I have found this lesson to be applicable in so many cases, particularly in investing. When you think of all the factors that can affect returns—economic factors, geopolitical issues, company specific factors, investor sentiment, government regulation, etc.—the tendency is to think that to be successful in such a complex environment you need to come up with a complex solution. Like my basketball play, complex investment solutions can often look great on paper, but fail to deliver.

I’ve interviewed hundreds, if not thousands of investment managers covering any asset class you can imagine. One of the things I’ve learned over the years is that if I can’t walk out of that interview with a good understanding of the key factors that will make their product successful and how that will help me, I’m better off passing on the strategy.

An instance that stands out to me is the time I visited a manager where we discussed an immensely elaborate strategy that tracked hundreds of factors to find securities that they believed were attractive. We visited the floor where the portfolio was managed by computing firepower and a collection of PhDs that rivaled NASA. You really couldn’t help but be impressed by the speed at which their systems could make decisions on new data and execute trades, and the algorithms they used to optimize their inputs used just about every letter in the Greek alphabet.

Raupp_Simple_3.28.14_1The conversation then went towards discussing how all of this translates to performance and it hit me—all of this firepower didn’t produce a result that I couldn’t get elsewhere from cheaper, less-complex strategies. So while I could appreciate all the work that went into putting the strategy together, I had a hard time seeing how the end results helped our investors. I felt that in creating an intellectually impressive structure, the firm had lost sight of the bottom line—delivering results to their investors.

This isn’t to say that all complex investment strategies aren’t worthwhile. We use many in our portfolios and over the years they’ve added significant value. We spend a lot of time analyzing the types of trades and opportunities that these managers look for and use. But I’ve found that if I can’t step back and articulate why I’d use a strategy in three or four bullet points, I’m better off walking away.

Most of the time you’re better off with the simple pick and roll.

The views expressed are those of Brinker Capital and are for informational purposes only.

Investment Insights Podcast – January 14, 2014

Investment Insights PodcastBill Miller, Chief Investment Officer

On this week’s podcast (recorded January 13, 2014):

  • What we like: Global synchronized recovery
  • What we don’t like: Complacency (too much bullishness) associated with the global synchronization, making the market vulnerable to pullbacks.
  • What we are doing about it: Minor hedging in some portfolios; looking at underlying health of global synchronized recovery as central event, with sentiment as a secondary event.

Click the play icon below to launch the audio recording.

The views expressed are those of Brinker Capital and are for informational purposes only. Holdings are subject to change.

Reading The Fine Print – Part Two

Jeff RauppJeff Raupp, CFA, Senior Investment Manager

In part one of my blog post, I discussed how important it is to read the fine print when selecting the right managers. “Things are not always what they seem, and by doing a little bit of digging, you can unearth some red flags that hopefully help you make a more educated decision, or at least ask the right questions.”

I left you with three warning signs of sorts that I’ve run into throughout my years of selecting investment managers:

  • Backtested numbers
    When you take a particular portfolio, or a process, and ask, “How would this have performed over a certain time period?”—that’s backtesting. There’s merit in doing this, but you really have to be careful on the value you place on the data. Anyone can build a portfolio that looks great using backtested data. If it’s a portfolio of mutual funds, just pick the ones that did the best. If it’s a quantitative model or a tactical model, just pick the algorithm that worked the best. You’ll never see a backtested quantitative or tactical model that doesn’t have a good outcome in recent markets.Not surprisingly, I have yet to come across a quantitative or tactical portfolio that has performed in actuality as well as it performed in backtesting. A backtest is good for telling you how the strategy would perform in various markets to help develop your expectation levels, but should not be used to decide if the strategy adds value.
  • Seed Accounts
    4.26.13_Raupp_FinePrint_2Firms will often start seed or model accounts to get a track record of performance started. These typically have little or no client assets and are often funded entirely by firm assets. While the firm can make the claim that they’ve been running money that way for a number of years, the reality was that their clients didn’t experience the front end of that.There are a few risks in play here. The firm could have run multiple seed accounts, discarding the ones that didn’t work and promoting the one that did. The objective itself or the universe of eligible securities may have changed before the strategy was offered to clients. As with backtested numbers, there is value in looking at seed performance, but if the backbone of a strategy’s pitch is great performance in 2008 and there were minimal assets that benefited, you have to ask, “Why?” Would the firm make the same decisions with billions of client assets that they did with $100,000 of seed capital?
  • Merged Track Records
    When firms combine, or merge products, often from multiple track records comes one track record. Ideally, the track record from the product that was most reflective of the surviving product would be used, but, more likely, the best track record will be the one that wins out. Knowing whether the track record is reflective of the current team, process and philosophy is vital.

Whenever you look at the performance of an investment strategy, you should always give careful consideration of exactly what you’re looking at. Reading through the disclosure is a necessity, as is asking questions about things that are unclear. The fine print can often help you make more educated decisions of where to invest.

Reading The Fine Print – Part One

Jeff RauppJeff Raupp, CFA, Senior Investment Manager

While at a carnival a few months back, our ten-year-old daughter entered my wife into a “contest” to win a free ocean cruise, unbeknownst to us. A few weeks and many soliciting phone calls later, we realized we had an opportunity for a teaching point on reading the fine print. While the picture on the entry box for the contest certainly looked appealing, with a handsome couple sunbathing by clear, blue Caribbean waters, the reality was that “winning” the contest gave you one free cruise—while accompanied by another adult paying full price, meals and transportation to point of departure not included, other fees may apply. And, if that wasn’t the kicker enough, your entry meant that you agreed to be solicited by the sponsoring firm. Oh, and you had to sit through a presentation while on the cruise.

The lesson? Often when something seems too good to be true, it is. Before buying/entering/joining something, make sure that you know what you’re getting into. In other words, read the fine print!4.26.13_Raupp_FinePrint

This is advice I’ve found extremely valuable in the investment management industry when selecting investment managers. Things are not always what they seem, and by doing a little bit of digging, you can unearth some red flags that hopefully help you make a more educated decision, or at least ask the right questions. Disclosures, often ignored, are invaluable when analyzing the performance of a strategy you’re considering.

Here are a few situations I’ve run into:

  • Backtested Numbers
  • Seed Accounts
  • Merged Track Records

Look out for my second post next week as I go deeper into these scenarios!

The S&P 500 in 2012

2012 was definitely a better year than it felt, with the S&P gaining over +13.0% on a price basis and +15.9% on a total return basis.

It was a great year to be invested in the global equity markets despite investors pulling out over $139 billion from equity mutual funds. Investors continued to pour into fixed income funds, adding over $300 billion during the year. (Source: ICI) The Barclays Aggregate gained +4.2% in 2012.

Below is a great snapshot of S&P 500 performance in 2012 from Bespoke Investment Group:

1.2.13_Magnotta_S&P_2012Perfromance