Posted: 16 Jan 2018 Last revised: 30 Nov 2018
Date Written: September 15, 2017
Institutional investors often sell funds (or fire managers) once they have underperformed the market over the last two to three years, typically replacing them with funds or managers that recently outperformed. This seemingly sensible strategy, intended to identify skilled managers, is often bad for future returns. No doubt some of the recently stellar managers have skill, but high alpha is often a result of luck, and the newly expensive holdings typically set the stage for poor future performance. Meanwhile recently disappointing managers often provide exposure to assets, factors, and strategies that have become inexpensive and are positioned for near-term success. In this article, we show that investors should urgently stop relying so heavily on past performance to choose investments. Performance chasing is a reliable path to poor investment results: too often it means that we sell newly cheap and buy newly expensive assets. When we supplement information about past performance with current relative valuation — compared with past norms — our decisions will be far more richly informed. We can determine whether the past performance was merely a consequence of portfolio revaluation, which may be more luck than skill, and we can determine whether the portfolio is now cheap or rich. And, we can predict mutual fund performance with better reliability than past methods.
Last year, in a series of articles, we demonstrated that relative valuations can predict future performance of equity factors and smart beta strategies. We now show that factor valuations can not only forecast factor returns, but can also forecast mutual fund alpha, and can provide a powerful tool to select the managers that have better chances of future outperformance. Factors and strategies can get relatively expensive after periods of great performance, and can get relatively cheap after periods of poor performance. When a factor or a strategy is cheap relative to its own history, it tends to perform well, while valuations that are high relative to historical norms predict subsequent underperformance.
Keywords: managers, performance chasing, asset allocation, smart beta
JEL Classification: G00, G10, G11