One topic that comes up over and over again in my conversations with Covestor clients is how to think about past performance when choosing investment managers.
It’s a controversial and complex issue, but I wanted to offer my two cents.
First off, performance is not a guarantee of future results — it never will be.
However, past performance can be one of many things that investors look at to understand how a manager invests. This can help frame reasonable expectations, so long-term investors don’t make the mistake of bolting from a strategy at the first sign of trouble.
Every mutual fund advertisement and prospectus has a disclaimer that says past performance is not indicative of future results. There’s a valid reason for that.
So, it might be helpful to focus first on how not to use past performance.
A recipe for disaster
The big danger of past performance is that investors simply chase the highest returns, whether it’s a stock or an investment manager. That’s usually a recipe for disaster.
As former Vanguard chief investment officer Gus Sauter explains, market segments go in and out of favor.
“In fact, frequently funds that outperform over one period will underperform over the next simply because they were riding a wave that dies out, just like an ocean wave that peters out when it reaches the shore,” Sauter writes.
Past performance can be troublesome because it’s difficult to determine whether good results were due to luck, or skill. That’s one reason why we use risk-adjusted performance for the portfolio managers on Covestor. We also award “badges” to portfolio managers who exhibit consistent, stable performance.
We want to help investors understand how much risk the manager took on to achieve his or her returns. Our transparent platform also lets investors view managers’ past trades to help them understand their investment approach.
In a sense, it’s not surprising that investors get so hung up on past performance. Increasingly, we’re using data to judge individual performance, whether it’s fantasy football or an employee’s value to the company.
No one knows the future, so it seems reasonable to look at the past for clues and guidance. But there is a right way and a wrong way to look at past performance.
Focus on investment process
I think past performance is just one of many tools that investors should use to evaluate investment managers.
The most important goal is to understand the manager’s process.
To that end, I believe that past performance can be used as a relative comparison tool to examine how specific strategies have performed during previous market conditions. How did the strategy perform in a bull market? A bear market? Over a full market cycle?
This might give us a glimpse into how that strategy may function if those market conditions were to reappear, if the manager is consistent in his or her approach.
Skin in the game
At Covestor, all portfolio managers have their own money invested. Conversely, in the mutual-fund business, nearly half of managers have no money invested in their own funds.
Also, the performance you see on Covestor is not back-tested, hypothetical returns — but rather the real returns experienced by our portfolio managers with their own money in their own brokerage accounts.
We believe this should be the rule and not the exception for active portfolio managers who are attempting to beat benchmarks.
As an online marketplace for investment strategies, we require every portfolio manager who runs an active investment strategy to put their own funds on the line before expecting clients to do so.
Our marketplace approach means we have something for almost every investor. There are passive investing strategies designed to keep costs very low while investing in a well-diversified basket of low-cost ETFs.
The Covestor Core portfolios with no management fees are a great example of these types of approaches that attempt to keep fees as low as possible. In fact, active and passive investing strategies can complement each other.
The bottom line is we don’t think investors should use past performance in isolation to try and pick “hot” managers. Instead, we think full transparency and past performance can help investors understand a portfolio manager’s investing process so they can make informed decisions when choosing who should manage their money.
Bhargav Shivarthy is the Director of Client Relations at Covestor.
DISCLAIMER: The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.